Supporting Capitalization Rates – Part II
In the first part of this series we talked about the importance of accurately estimating the capitalization rate within a direct capitalization analysis and briefly introduced four common methods used to estimate a capitalization rate (OAR). In this part of the series we will more thoroughly describe and define these four methods which include market derivation, band of investment, debt coverage ratio, and investor’s survey. As we discussed in the first post, deriving capitalization rates from comparable sales is the favored method.
A market-derived capitalization rate can be characterized by several factors. It is the rate of return on the entire purchase without taking into consideration who contributes the funds (i.e. bank or REIT). The market derived rate is not influenced by the structure of debt and equity. The market derived rate indicates the connection between one year’s net operating income and the total purchase price. The market derived rate does not clearly consider projected future income or changes in property value. The market derived rate represents a going-in rate of return. The reciprocal of the market derived rate is a net income multiplier. If a market-derived capitalization rate is not able to be estimated, the next most credible methods include the construction of an OAR through component parts. The band of investment and debt coverage ratio methods represent two ways to construct an estimated OAR.
Band of investment analysis, by definition, “is a technique in which cash flow rates attributable to components of a capital investment are weighted and combined to derive a weighted average rate attributable to the total investment.” Because most investments are purchased with debt and equity capital, the overall capitalization rate must satisfy the return of both investors. The debt coverage ratio method, or DCR method, is based upon standard underwriting guidelines determined by commercial lenders. It is based on lender’s debt coverage ratio which represents the amount of net operation income needed to cover the debt associated with a property.
Finally, the Investor’s Survey can be used to estimate the OAR and is considered a good check on market-derived and constructed rates. Investors surveys are published by several different outlets and can provide good support in estimating a capitalization rate. In the next part of this series, we will look at the strengths and weaknesses of each of these approaches.