In this post, we describe three methods to arrive at a capitalization rate. The first, market extraction, reflects what the market is doing. The second, band-of-investment, allows you to take into account the cost of equity and debt financing. The third, build-up-method, adjusts the capitalization rate to your perception of risk.
Market extraction is a popular approach to estimating the capitalization rate. Let us say we found three recent comparable sales:
We now get a sense of what the market is actually doing: it is valuing comparable properties at a capitalization rate of 10 percent.
By design, the market extraction approach does not take into account any changes in equity and debt financing. Yet, if interest rates changes to 8 percent from 3 percent, would it not affect value of our property? The band-of-investment approach considers this issue.
Band-of-Investment: we now use debt and equity financing to determinate a market rate of capitalization. To illustrate: let us say we purchase a property using 65 percent financing at a rate of 8 percent per annum, amortized over 20 years. The future obligation to pay off our lender in 20 years, not just the 8 percent rate should added to our annual cost of debt financing. This consideration is called a sinking fund factor and can be calculated to be 2.4 percent. Our cost to finance the purchase is 10.04 percent, the sum of 8 percent plus the 2.04 percent.
Let us assume we require a rate of return of 12 percent per annum. We can calculate the weighted average to be 10.73 percent.
The previous approaches used market factors such as rate of debt financing or the purchase price of properties by other investors. However, what if think we think the market is wrong? That investors are overvaluing properties and required rates of return are low compared to risk taken? The built-up approach can be used.
Built-up method: the rate of capitalization is a composite of the following: (1) pure interest, i.e., interest that can be secured on government bonds, (2) rate for nonliquidity, rate necessary to compensate for a relative inability to cash in the investment, (3) a recapture premium, i.e., return of investment or an adjustment for appreciation, and (4) rate of risk. The risk rate varies with the type of investment.