Property Value: The Capitalization Approach

When arranging a loan or investing in real estate, understanding the use of capitalization approach (“Cap Rates”) is critical to the decision-making. This subject is important to commercial realtors, lenders, developers, and investors.

Definition of Capitalization Rate (Cap Rate)

Cap Rates represent the ratio of Net Operating Income (“NOI”) to the property asset value (NOI / Value = Cap Rate). The income capitalization approach does not consider whether the property is free and clear with no debt service. NOI is simply gross rents, less a vacancy allowance, less operating expenses. If you have similar properties with similar characteristics in a similar geographical location that have recently sold in arm’s length cash transactions, you can calculate the comparison cap rates. Also, cap rates may vary, even in the same geographic location, depending upon the multiple types of properties. Examples are, Class A vs Class C office, industrial, apartments, new modern styles with amenities vs older dated properties. Additionally, the strength of the tenancy from national credit tenants with long term leases, vs a mom and pops’ month to month tenancy would result in a different cap rate. Most likely the mom and pop tenancy would reflect a higher cap rate. An exception would be where the national credit tenant locks a lease/rental rate that does not increase as the market dictates or anticipates, reflecting what is referred to as below market rent. The mom and pop, on the other hand, could be converted to a market lease relatively quickly, by either acquiring a new tenant or by renegotiating the lease with a higher rent

Market rents should be used rather than actual rents.  In most cases, actual rents are lower. When there is a lease up period, such as with new construction of an income producing property, future cash flows need to be estimated to the point of income stabilization, then the future stabilized income is discounted, utilizing an estimate of a capitalization rate, and a discount rate. Work with a good appraiser on this?

Once the market Cap Rate has been determined, you can apply it to the NOI and cap rate analysis of the property under consideration to indicate the probable market value.

At this point, I want to credit competent commercial appraisers, who can assist us to find the correct Cap Rate. I would not try to do it myself, without the assistance of an appraiser with local experience.

Let’s say for example that: The market Cap Rate for a commercial property with triple net leases (“NNN”) has been determined to be 6.5%. The 10,000 square foot multi-tenant property under consideration generates monthly rents of $1.50 per foot. After applying a 10% vacancy collection and loss factor and expenses of 5% for management and reserves, the NOI is $153,900.

10,000 sf X $1.50 = $5,000 Per mo. X 12 Mos. = $180,000 gross income

$180,000 - $18,000 10% vac. = $162,000 - $8,100 5% exp. = $153,900 NOI

$153,900 NOI / .065 Cap Rate = $2,367,692 asset value

From an investment standpoint Cap Rates can also indicate a prevailing rate of return before debt service and can help a lender/investor to measure both return on invested capital and profitability based on cash flow. An informed lender/ investor should understand that there may be dramatic variations in a property’s value when unsupported or unrealistic Cap Rates are applied.

Why do we use Cap Rates?

The capitalization approach is used as a “comparative method” of valuing property based on similar geographic locations, similar properties, and similar risks that would yield a comparable rate of return. Once the value is established, the loan to value ratio can be calculated to determine if it falls within loan underwriting guidelines.

Of course, Cap Rates are only one metric. They represent a snapshot of the market at the time of investment and they do not take debt service or financing costs into consideration. Therefore, if a borrower is going to finance his investment, as most people do, then further analysis such as cash on cash return would be useful. Sophisticated loan underwriters and investors will also do an Internal Rate of Return calculation. These calculations assist in establishing that the collateral property is not only income producing but a worthwhile investment.

Cash on Cash Return

Cash on cash return is a quick analysis that can be done to determine the yield on an initial investment. It is developed by dividing the total cash invested (the down payment plus initial cost), or the net equity into the annual pre-tax net cash flow.

Assume the borrower purchased the property which costs $1,200,000 and provides an NOI of $100,000, with a $400,000 down payment representing the equity investment in the project. The cash on cash return for this property would be:

$100,000 / $400,000 = 25%

If the borrower were to purchase the property for all cash, his cash on cash return would be:

$100,000 / $1,200,000 = 8%

It is clear from this formula that leveraging or financing real estate transactions will yield a higher cash on cash return, provided the transaction is financed at a favorable interest rate. 

Internal Rate of Return

The internal rate of return (“IRR”) refers to the yield that is earned or expected to be earned for a given capital investment over the period of ownership. The IRR for an investment is the yield rate that equates the present value of the future benefits of the investment to the amount of capital invested.  The IRR applies to all expected benefits, including monthly and yearly cash flow and the proceeds from resale at the termination of the investment. It can be used to measure the return on any capital investment, before or after income taxes. Ideally, the IRR should exceed the cost of capital.

Is there an ideal Cap Rate?

Each growth/investor should determine their own risk tolerance that will reflect the ideal for their portfolio. A lower Cap Rate means a higher property value.  A lower Cap Rate would mean that the underlying property is more valuable but that it may take longer to recapture the investment. Whichever Cap Rate is targeted will represent the annual return overtime (before financing costs and taxes) an investor can expect to make on the investment at the time the property is acquired. If investing for the long term one might select properties with lower Cap Rates. If investing for cash flow, look for a property with a higher Cap Rate. It’s valuable to look at historical Cap Rates and Cap Rate trends on the specific property type in a specific geographical location. Declining Cap Rates may mean that the market for your property type is heating up. A Cap Rate that is either at the top of the range or at the lower end of the range is likely to change and it may be wise to adjust the analysis and/or investment strategy accordingly. And make certain, when comparing Cap Rates, to compare the same geographical locations and property types, apartments to apartments. For Cap Rates to remain constant on any given investment, the rate of asset appreciation and the increase of NOI it produces will occur in tandem and at the same rate.

Below are examples of the affect changes in NOI and/or Cap Rates on asset values:

As NOI increases and Cap Rates remain the same, asset value increases.


$300,000 / .06 = $5,000,000

$350,000 / .06 = $5,833,000

$400,000 / .06 = $6,666,666

$450,000 / .06 = $7,500,000

The effect on Asset Value when the Cap Rate varies.


$500,000 / .03 = $10,000,000

$500,000 / .04 = $ 8,333,333

$500,000 / .05 = $ 7,142,857

$500,000 / .06 = $ 6,250,000

Cap rates are driven by property type, geographic location and market sentiment. During the recent recession, as property values fell, Cap Rates increased dramatically for some property types in certain areas of the country. The improving economy has reversed that trend. 

Correlation Between Cap Rates and US Treasuries  

The US Ten Year Treasury Note (“UST”) is deemed to be the risk-free investment against which returns on other types of investments can be measured. Interest rates on UST have been on a broad decline for many years but have recently began to rise.  There is now concern that as interest rates begin to rise, so will Cap Rates will rise and consequently there may be reduction in asset values over time? With so many uncertainties in the market, and growth projections constantly being revised, the spread between UST and Cap Rates have not remained constant. 

Also, the discussion of the above, affect of cap rates resulting from artificially low interest rates, inflationary expectations, and anticipated increased interest rates need to be discussed in another article.


Cap Rates are a good starting point in analyzing a property’s value, but they should not be the only analysis. It is prudent to look at the cash on cash return and the internal rate of return as well. Factors such as changes in NOI, vacancy rates, and changes in neighborhood property values are just a few other considerations. Also recognize, that Cap Rates may vary widely in different geographic areas. Property appreciation, perhaps one of the greatest reasons for investing in real estate, is not part of the Cap Rate calculation. For investors, the tax benefits of owning commercial real estate may, in and of themselves, be the driving force to make such an investment. If the property is to be leveraged, then there may be write-offs for loan fees, interest expense, depreciation and investment expenses. Taking all these factors into account can help achieve the basis for making a sound business decision.

As interest rates go up, will this automatically cause Cap Rates to rise, and values to go down. Not necessarily in the short term. Remember that increased debt service based upon higher interest rates is not considered in the capitalization approach. But, over time as interest rates go up, borrowers will feel the sting of higher debt service payments. Some property transactions may become less appealing financially. As purchasers and borrowers elect not to purchase, that may compound and create more unsold inventory. Some sellers may get desperate and reduce price to sell quicker. The lowered price would result in an increased cap rate. On a macro level, this could result in lowering all real estate prices. 

How dramatic can lowered real estate prices be over time? As we witnessed 10 years ago that the contagion effect could spread and result in dramatically lower values, and substantially increased Capitalizations Rates.

Martin Hudler is a serial real estate investor and businessman who specializes in estate planning and real estate investment throughout the company.

City Rundown — New York City

As one of the country’s top-performing economic regions, there are many reasons to live and do business in New York City, especially considering:

  • Silicon Alley, centered in Manhattan, generated over $7.3 billion in venture capital investments.
  • In 2015, nearly 60 million visitors/tourists generated 61.3 billion in economic impact.  
  • New York City is the second largest city for filmmaking and tv show production in the US.
  • New York City is the largest media market in North America, with conglomerates like Time Warner, The New York Times Company and NBC Universal.
  • Seven of the world’s top eight advertising agencies are headquartered in New York.
  • Over 600,000 students are enrolled in New York City’s 120+ higher education institutions, which is the highest number of students in any US city.

New York City — By the Numbers

28,000 acres Parkland

New York City has over 28,000 acres of municipal parkland and 14 miles of beaches. Although people are more familiar with Central Park, the largest municipal park in the city is Pelham Bay Park in the Bronx, with 2,765 acres. Central Park, an 883-acre park in middle-upper Manhattan, is the most visited urban park in the United States, with 40 million visitors in 2013.

2 largest stock exchanges

Due to Wall Street and the Financial District of Lower Manhattan, the city has been called the economic leader of the world. The city is also home to the world’s two largest stock exchanges by total market capitalization — the New York Stock Exchange and NASDAQ.

8.5 million people

New York City is the most densely populated city in the US (8.5 million, and 24 million in the metro area).

800 Languages

There are as many as 800 languages spoken in the city.

1.39 trillion GMP

The gross metropolitan product of 2014 was 1.39 trillion.

60 million visitors

The city received a record of nearly 60 million tourists in 2015.

120 colleges 

The city boasts over 120 colleges and universities, including Columbia University, New York University and Rockefeller University, which have been ranked among the top 35 in the world.

Nearly 6,000 High-Rises

As of 2011, New York City had 5,937 high-rise buildings, of which 550 completed structures were at least 330 feet high, with over 50 completed skyscrapers taller than 656 feet.

The Domino Sugar Refinery | Photo Credit:  The New York Post

The Domino Sugar Refinery | Photo Credit: The New York Post

Developments in 2017 — 

New York City is one of the most expensive real estate markets in the world, and it's not going to decrease or slow down anytime soon. Here are some of the most anticipated projects of 2017:

  • 35 Hudson Yards, the David Childs and SOM-designed condo building.
  • The 14-story 242 Broome Street, as will Handel and SHoP’s 24-story rental building at 115 Delancey Street (with a movie theater in the base.)
  • Six buildings at Brooklyn’s 22-acre megaproject Pacific Park are in various stages of construction, three of which will open in 2017.
  • The Domino Sugar Refinery in Williamsburg, with 396 apartments.
  • Vornado Realty Trust’s crown jewel, 220 Central Park South, which was designed by Robert A.M. Stern, is 66 stories with 100 off-market condos. 
  • The first phase of the Second Avenue Subway will extend 8.5 miles along Manhattan’s East Side, from Hanover Street to 125th.
  • The city’s new fleet of 19 ferry vessels.

Martin Hudler Headshot.jpg

Martin L. Hudler

Hudler through various entities, sources, acquires, develops and finances real estate opportunities including commercial, office, industrial, retail, multifamily and mixed-use assets. Many of the properties which are acquired, need to be repositioned in order to maximize the true market value of the asset. Properties are closely managed and strategically sold at a time to garner above market returns to our clients and shareholders, or in the alternative, if properties are producing above average returns, they are held for a longer period of time.

City Rundown — Dallas

As one of the country’s top-performing economic regions, there are many reasons to live and do business in Dallas, especially considering:

  • Dallas is the fourth most populous metropolitan area in the US.
  • 20 companies from Dallas–Fort Worth made the 2016 Fortune 500 list.
  • The cost of doing business in Dallas is 5% lower than the national average.
  • Dallas boasts the largest urban arts district in the country, spread over 20 square blocks and 68 acres.
  • Dallas is the fourth-largest employment center in the nation (behind New York City, Los Angeles and Chicago). 

Dallas Rundown

The fifth largest metropolitan economy in the US (2014 real GDP was over $504 billion). The fourth-largest employment center in the nation (behind New York City, Los Angeles and Chicago) with more than 3.5 million jobs. Home to the third-largest concentration of Fortune 500 companies in the nation (behind New York City and Houston).



Texas has been the top state in the country for business for 12 years in a row.
(source: Chief Executive Magazine)

2nd highest

overall population gain in the US from 2014-2015.

1 square mile

in the city has the greatest concentration of award-winning architecture.

20 companies

from Dallas-Fort Worth made the 2016 Fortune 500 list.
(source: Dallas Business Journal)

Nearly 26 million

visitors came to Dallas in 2015.
(source: Dallas Convention & Visitors Bureau)

7th largest

municipal park system in the US.

7,000-acre urban forest

Great Trinity River Forest is the largest urban hardwood forest in America.

201+ companies

moved to, or grew their business in, North Texas in 2015.
(source: Dallas Business Journal)

Dallas Cowboys

is the most valuable sports franchise in the world.
(source: Forbes)

20 square blocks

and 68 acres make up the largest urban arts district in the US.

$24.02 / square foot

average office space rental rate in late 2016
(up 23% from 5 years ago)
(source: CoStar Realty Information)

22 million square feet

of industrial product under construction in 2016, more than any other US market.
(source: CoStar Realty Information)

Martin Hudler Headshot.jpg

Martin L. Hudler

Martin brings over 40 years of real estate expertise working throughout the US and Canada, specializing in dealing with real estate assets in bankruptcy court, difficult real estate developments, and investments such as build-to-suits for industrial and commercial or retail projects with an emphasis on multi-family development and existing multi-family projects.