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Proforma Income Statement Terms and Methods
for Investment and Development Cash Flow Analysis

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Capitalization Rate article

How is the Capitalization Rate calculated for commercial real estate investments and developments? What are the factors that the Capitalization Rate takes into consideration when shown in a proforma income statement, and what is ignored? Why is the Capitalization Rate useful for investment real estate? These are the questions that are explored using the Proforma Example in this article.

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Initial Investment = $3,300,000.00

	2010	2011	2012	2013	2014	2015
Total Gross Income	$365,472	$372,443	$370,410	$376,040	$384,217	$414,321
Less: Vacancy & Credit Loss	19,084	3,202	14,620	5,049	3,501	50,321
Effective Income	$346,387	$369,241	$355,790	$370,992	$380,717	$364,000
Total Operating Expenses	$69,400	$71,244	$73,141	$75,094	$77,103	$79,170
Net Operating Income	$276,987	$297,997	$282,649	$295,898	$303,614	$284,830
Capitalization Rate	8.39%	9.03%	8.57%	8.97%	9.20%	8.63%

In this case the 2010 Capitalization Rate was calculated by:

2010 Net Operating Income (NOI)	$276,987
divide by the Price	$3,300,000.00
equals the 2010 Cap Rate	8.39%

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Considers:

• Price, Scheduled Income(Current Year Only), Vacancies (Current Year Only), Expenses (Current Year Only)

Ignores:

• Time Value of Money, Sale Proceeds, All Financing (Loans), Other Years NOI, All Taxes
  
  ... and a lot of other things

Why is Capitalization Rate useful?

The Cap Rate is a core ratio in commercial real estate investments and is very useful because it is so simple. All you really need is a reliable 1-year Net Operating Income (NOI) number. For this reason it is often used to create a beginning purchase price and ending sale price. Also, it can be used as a Return on Investment (ROI) or Profitability Ratio as shown in the example above.

Use of the Cap Rate to create a beginning purchase price or an ending sale price Net Operating Income (NOI) is part of the Cap Rate, and it is important to understand which NOI is being used --- Last Years, Next Years, or a 'Current Year' NOI created by multiplying the current month by 12? Use of each of these NOI values has issues:

• Last Year's NOI is virtually never used to create a beginning purchase price, but is often used to determine ending sale price. The argument in favor of this use is that it is a more "conservative" valuation method. However, if a prospective buyer were to be valuing the property at the date of sale, he/she would most certainly be looking at an APOD showing either the Current NOI at the sale date or the Next Year's NOI, together with the corresponding Cap Rate. Since that would be the buyer's perspective at that time, I believe the property's projected sale price should be determined using either of those NOI values.
  
  
• 'Current Year' NOI (created by multiplying the current month by 12) is typically shown as the NOI (and used in the Cap Rate) in the APOD report. This NOI value has the advantage of taking the cash flow of the current month and looking at the next year without seemingly making any assumptions about the next year. However it does implicitly make the assumption that all the NOI components during that month continue for the whole year. For instance, all the vacant spaces are assumed to stay vacant, expenses don't escalate, and so on. When the Cap Rate is being used to determine a future sale value, this method makes it more difficult to understand where the sale value number is coming from, since you need to see the monthly number to recreate the 'current year' NOI. For self storage and apartment type properties with lots of turnover this might be the most accurate estimation method for future sale price, but for office and retail properties, where projected vacancies occur irregularly due to lease expirations, use of a single month's projected NOI can lead to false sale value projections.
  
  
• Next Year's NOI is typically used to determine a ending sale price for a property projection. More rarely, it may be used as the NOI for a Cap Rate used for a current sale price. When used for a current sale price, it must make assumptions about the revenues and expenses to be expected during the next year, which can be problematic. When used for an ending sale price, such assumptions must also be made, but making them may well be the best available method of valuation (particularly for leased properties such as office and retail investments.
  
  

What is the Capitalization Rate Sensitive to:

Price, Expenses, and Revenue Items (Rent Increase/Decrease, Vacancy, Reimbursements, Free Rent)

The Capitalization Rate is shown in these planEASe Reports:

• Sensitivity Analysis ('What if')
• Risk Analysis (Monte Carlo Simulation)
• Annual Property Operating Data (APOD)
• Proforma Income Statements
• Annual Statements

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Written by
Michael Feakins, CCIM
of planEASe Software