Capitalization Rate Development
Basic Techniques and Sources for Cap Rate Information
Sponsored by the Middlesex County Assessors Association
What is a Cap Rate?
Any Rate used to convert
income into value.
What is a Cap Rate?
Formal Definition
Capitalization is the process of converting income from
a property into an expression of capital value. Therefore,
a capitalization rate is nothing more than the
mathematical relationship between the income and the
capital value. There are two basic methods of
capitalization: the direct method and the yield method.
There are many rates that are used in capitalization.
The Appraisal Institute
• Gross Rent or Gross Income Multiplier
• Band of Investment
• Debt Coverage Ratio
• Overall (Direct or Market Derived) Cap Rate
• Yield Ratio
– Discount Rate
– Internal Rate of Return (IRR)
– Equity Yield Rate
Types of Capitalization
Band of Investment
What is it?
It is a blending of the weighted
rates of mortgage and equity
into an overall rate.
Band of Investment
Major Advantages
The information required to calculate a
cap rate via the Band of Investment
technique is readily available.
Considers both equity and financing
aspects.
Band of Investment
Major Disadvantages
The Band of Investment technique has a
powerful financing influence.
It is easy to misapply dividend rates to
properties that are not comparable or use
financing terms, or financing ratios, that
are not typical for the property type.
Band of Investment
Components and Calculations
Assumes an investor would pay cash for
a portion of the property and finance the
remaining balance of the purchase price.
The cash portion is known as the “equity”
component and the financed portion is
known as the “Debt” component.
Band of Investment
Components
Holding Period:
The length of time the typical investor expects to hold the property.
LTV (Loan to Value - M):
This represents the loan or debt portion of the property investment in terms
of a percentage.
Equity Dividend (Re):
The "cash on cash" return (usually reflecting the first year