Cap Rates vs Yield Rates in the Income Approach

synopsis, crea, completerea, nana smith stamford ct

Synopsis  In the income approach analysis of real property value, there is often confusion as to which rates to use and what these rates represent. In the direct capitalization approach, the cap rate is merely the ratio of stabilized net operating income to sales price – i.e. the property dividend rate.

In discounted cash flow analyses or other yield capitalization techniques, future cash flows are discounted by use of a discount rate which is a true yield rate – which can be directly compared to other before tax, unleveraged return rates such as stock and bond yields, etc.

discussion, crea, competerea, compete real estate, answers, nana smithDiscussion The premise of the Income Approach is that the value of a property is the present value of future benefits of property ownership. All of the Income Approach techniques discount or translate, in some fashion, future net cash flows to a current property value. This is usually done on a before tax, before financing basis and usually deals with the net income stream from the real estate – before financing charges, depreciation or taxes – what appraisers call Net Operating Income (NOI).

dirrect capitalizationDirect capitalization is simply applying an appropriate overall capitalization rate to next year’s stabilized NOI. This cap rate is the property dividend rate or, more popularly, simply the ratio of next year’s NOI to sales price – usually supported by direct market evidence gleaned from other market sales.

cap rate, completerea, CREA, compete real estate asnwers, nana smith, appraiser, stamford, ctProperties that have high demand and / or low risk have cap rates in the low end of the range. Properties that have high risk and / or low demand have cap rates in the high end of the range. Put another way, savvy investors try to pay high cap rates (i.e. relatively low price relative to NOI) while retail type buyers for popular properties have to pay low cap rates (i.e. demand bids the price up for a given income stream).

The strength of Direct Capitalization is its simplicity and familiarity with market players – particularly for smaller commercial properties. A variation of this approach is also used in small rented residential properties – where a gross rent multiplier is applied to stabilized rents. The gross rent multiplier is simply the sales price divided by next years’ stabilized gross rents. Obviously, to be used effectively, the appraiser must know the terms of the lease – i.e. who pays what and also what the likely occupancy will be next year.

Loan Real Estate Stocks
Cap/Dividend Mortgage Constant NOI/Sales Price 1/PE Ratio
Yield/Discount Rate Interest Rate Discount Rate Dividend rate + Price Growth Rate

In other words, the discount rate is the property yield rate and includes a component related to annual income (read an annual dividend with stocks or, alternatively, NOI with real estate) and appreciation at resale (future stock price with stocks or, alternatively, future sales / reversion price of the property at the end of the investment term with real estate). The above discussion reflects property yields that are appropriate for the overall property cash flows. Obviously, a similar analysis could be done for only the equity component of future cash flows (i.e. NOI less debt service) – the resulting present value of the equity would then be added to the mortgage amount to arrive at an indicated property value.

inally, support for cap rates is usually direct market evidence from other sales and these market cap rates are not adjusted but simply used to bracket or select an appropriate cap rate for the subject property. Remember, next year’s NOI is usually used for the subject and therefore should be used on the comparables.

Support for yield rates is usually from market indices such as published yield rates on real estate from surveys of national lenders or from investor interviews or from yield rates required from other alternative investment options.

This article presented By Thomas A. Steitler, MAI

—-

Phone: +1 203 858 6727

Office: +1 203 212 3788

Complete Real Estate Answers, Inc.
27 Fifth Street, 2nd Floor, Stamford CT 06903

Nana G. Smith, Proprietor

Web & Blog: CompleteREA.com (you are here)
Facebook
Twitter
Google+

C.R.E.A. – comment using this form to be in touch :

 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s