Derived Capitalization Rate



	~ Real Estate Investment and Development Software since 1981 ~			Log In \| Shopping Cart \| Check Out

By Frank Gallinelli

In an earlier article (How to Estimate Resale Value Using "Cap" Rates) we discussed income capitalization in general terms. In that article we used what is commonly called the market capitalization rate, i.e., the rate that prevails for a particular type of property in a given market. Now let's dig a little deeper into our topic and look at what we call the Derived Cap Rate.

It would not be unreasonable to ask, "Where do cap rates come from?" If the stork doesn't bring them, who does? The cap rate we have been talking about thus far is the rate that prevails in our particular marketplace; hence it is usually called the Market Cap Rate. We can dissect that rate, however, using an approach called "Band of Investment" or "Derived Cap Rate." The Derived Cap Rate breaks the calculation of the return into two components: financing and equity. The lender is getting a return on the financing; the investor is getting a return on the equity; the Derived Cap Rate is the weighted average of the two.

A simple example should illustrate the process. Examine this calculation; we'll explain it below:

0.80 x 0.10785939 = 0.086287514 financing cap rate
0.20 x 0.12000000 = 0.024000000 equity cap rate
= 0.110287514 derived cap rate

We are purchasing a property with 20% equity and 80% financing. We find that loans are available for 15 years at 7%. We'll start with the financing component, the so-called "lender's cap rate." We need to introduce a new term here: Mortgage Constant. The Mortgage Constant equals the payment amount on a loan of $1 at a given rate and term. (Tip: Use $1,000,000 as the amount so that you can display a meaningful number of digits in the payment. Then move the decimal point 6 places to the left. You should end up with 0.00898828.)

Since we are dealing with annual cap rates, we need to multiply the monthly Mortgage Constant by 12, getting and annual constant of 0.10785939 (rounding may affect this slightly). This is the lender's cap rate. Since the lender is contributing 80% of the money to this deal, multiply that by 0.80 to get the lender's portion of the Derived Cap Rate.

What is the investor's cap rate? The classic approach is to identify a "risk-adjusted safe rate." The logic here is that we take a safe rate such as the current T-Bill and then bump it up to account for the risk and travails of being a real estate investor. (With a T-Bill we always get paid and the Treasury Secretary never calls us in the middle of the night to tell us the toilets are stopped up.) Multiply by 0.20 for the investor's portion of the Derived Cap Rate.

But bump it up how high? We may detect a bit of circumlocution in our attempt to derive a cap rate that is more objective than the Market Cap Rate, because ultimately we need to make a subjective judgment as to how much of a risk adjustment we're going to make. Investors being competitive creatures, we're not going to settle for less than everyone else in our market is getting; and although we might want even more than that, wanting and expecting are two different things. It comes down to this: Our risk adjustment is typically market-driven, so we probably end up right back with the Market Cap Rate.

Does this mean our entire derivation exercise was pointless? Not really, because we can run this process backwards if we want to discern some useful information: namely, what kind of cash-on-cash return are investors in our market really getting? Consider the example above. If we know that the Market Cap Rate is 11% and that the typical financing available is for 7%, 15 years with an 80% loan-to-value ratio, we can disassemble the weighted average to find out what the equity cap rate is. By doing so, we know that we should expect to achieve a 12% cash-on-cash return in our first year of ownership.

~ Creating Real Estate Investment and Development Software since 1981 ~