This document provides an in-depth look of the capitalization rate, or cap rate, metric commonly used in real estate.

1. A primer on
this widely
used, but
seldom
understood,
real estate
metric
UNDERSTANDING
CAPITALIZATION RATES
OR CAP RATES

2. WHAT IS A CAP RATE ?
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¡ Rate of interest or return that is considered as “reasonable”
return on investment
¡ Rate used to derive an estimate of property value based on
net income
¡ Preliminary test for reasonableness of purchase price of
property
¡ Inverse of a multiple
¡ Used in Direct Capitalization as follows:
R = NOI1 ÷ V
where, R is Capitalization Rate or Cap Rate
NOI1 is Net Operating Income for the first year of holding period
V is Value of property

3. CAP RATE VS. DISCOUNT RATE
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¡ Cap Rate is related to a Discount Rate
§ Discount rate, investment yield, or internal rate of return is the risk
adjusted required return for an investment when compared with
returns earned on competing investments
¡ Relationship is as follows:
R = r − g OR r = R + g
where, R is Capitalization Rate or Cap Rate
r is Discount Rate
g is Annual Growth in Income
Cap Rates will equal Yield Rates only when the
expected annual growth in income is Zero

4. RISK AND CAP RATES
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HIGH
Property
Value
Low
Cap
Rate
Low
Risk
LOW
Property
Value
High
Cap
Rate
High
Risk
Return on Investment is inversely correlated
to probability of Return of Investment

5. METHODS FOR ESTIMATING A CAP RATE
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Sales
Comparable
Approach
Gettel
Approach
Band of
Investment
Approach
Akerson
Approach
Ellwood
Approach

6. SALES COMPARABLE APPROACH
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Cap Rate: Calculated as NOI ÷ Price
1 Subject Cap Rate: Comparable properties must be carefully analyzed before choosing the appropriate
Cap Rate so as to accurately reflect overall similarity
Subject Sales Comparables
Property 1 Property 2 Property 3
Price $10,032,103 $10,000,000 $9,750,000 $10,250,000
NOI $625,000 $625,000 $600,000 $645,000
Cap Rate 6.23% 1
6.25% 6.15% 6.29%
Use only when sufficient comparable
sales data is available

7. RONALD GETTEL APPROACH
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Takes into account lender’s
perspective
Loan-to-Value 70.00%
x
Debt Service Coverage Ratio 1.25x
x
Loan Constant (Debt Service ÷ Loan Amount) 7.92%
Loan Annual Interest Rate 5.00%
Amortization in Years 20
Cap Rate 6.93%

8. BAND OF INVESTMENT APPROACH
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Equity Dividend Rate (EDR): Current Before-Tax Cash Flow ÷ Invested Equity
1 EDR: Also referred to as current return on equity (ROE) or cash return on invested equity for equity investor
Takes into account investment
criteria of debt and equity
Item Rate Weight Contribution
to Cap Rate
Equity Equity Dividend Rate Equity-to-Value
8.00% 30.00% 2.40%
Mortgage Loan Constant Loan-to-Value +
7.92% 70.00% 5.54%
Loan Annual Interest Rate 5.00%
Amortization in Years 20
Loan Constant = Debt Service ÷ Loan Amount 7.92%
Cap Rate 7.94%

9. CHARLES AKERSON APPROACH
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Takesintoaccountinvestmentcriteriaof
debtandequityandaccountsforloan
repaymentandchangeinpropertyvalue
Item Rate Weight Contribution
to Cap Rate
Equity Equity Dividend Rate Equity-to-Value
8.00% 30.00% 2.40%
Mortgage Loan Constant Loan-to-Value +
7.92% 70.00% 5.54%
Loan Annual Interest Rate 5.00%
Amortization Period in Years 20
Loan Constant 7.92%
Cap Rate - Band of Investment Approach 7.94% (a)
Adjustment 1: Equity Build-Up or Loan Paid-Off 1.83%
Loan-to-Value 70.00%
Holding Period in Years 10
+
Sinking Fund Factor - SFF 6.90%
Loan Paid-Off Over Holding Period 37.78%
Adjustment 2: Change in Property Value 0.69%
Appreciation Over Period 10.00%
SFF 6.90%
Total Adjustment 2.52% (b)
Cap Rate 5.43% (a) - (b)

10. L. W. ELLWOOD APPROACH
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Item Key General Factor Used
K J
Equity Dividend Rate r 8.00%
Loan-to-Value mr 70.00%
Amortization Period in Years t 20
Loan Annual Interest Rate i 5.00%
Loan Constant mc = -PMT(i,t) 7.92%
Holding Period in Years n 10
Sinking Fund Factor SFF = r/((1+r)^n-1) 0.0690
% Paid Off Over Holding Period P = (mc-i)/(-PMT(i,n)-i) 37.78%
PV Factor Ordinary Level Annuity An = (1-(1+r)^(-n))/r 6.710
FV Factor Sn = (1+r)^n 2.159
Change in Value Over Holding Period Dv 5.00%
Constant Change in Income Per Year g 2.00%
Change in Income Over Holding Period Di 5.00%
K Factor K = (1-((1+g)^n/Sn))/((r-g)*An) 1.081
J Factor J = SFF*(n/(1-(1/(1+r)^n))-(1/r)) 0.423
Cap Rate - K Factor Cap (K) = (r-mr*(r+P*SFF-mc)-Dv*SFF)/K 5.34%
Cap Rate - J Factor Cap (J) = (r-mr*(r+P*SFF-mc)-Dv*SFF)/(1+Di*J) 5.65%
Ellwood formula was later restated
as Akerson’s approach
KFactor-Factorusedtoconvertstream
ofincomechangingatconstantratioor
compoundingrateintolevelequivalent
payments
JFactor-Factorusedtoconvertvariable
streamofincomeintolevelequivalent
payments

11. CONTACT US
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Disclaimer: The information contained herein may be subject to errors, omissions, changes in assumptions and, other factors. We do not provide
any guarantees, express or implied, and/or make any representations as to the accuracy of the assumptions used and/or other information
contained herein. All information contained herein is only for purposes of illustration, and should be independently verified by the user. The
analysis represents our interpretation and is NOT intended to replace information received from tax and/or accounting professionals. The user is
advised to conduct their own due diligence and consult with their advisors prior to making any decision.
For real estate consulting and
advisory, please contact:
Mr. Adnan Tapia
Email: atapia@ploutusadvisors.com
Tel: +1.424.274.3561
Ploutus Advisors, LLC
1875 Century Park East, Suite 700
Century City
CA 90067
Adnan is a Principal at Ploutus Advisors, LLC; a boutique real estate
investment and advisory firm based in Los Angeles, California.
Over a period of 18 years, Adnan has worked on 16+ million square
feet or US$2.5 billion worth of US and India focused real estate
transactions across several product types (office, industrial, retail,
residential, hospitality, mixed-use, land) and life cycles in areas such
as real estate private equity, financial consulting, acquisitions and
development.
Adnan graduated with a MBA in Banking and Finance from Case
Western Reserve University, Ohio, and was nominated to The Honor
Society of Beta Gamma Sigma. He also holds a Master in
Engineering from Cornell University, New York, and Bachelor in Civil
Engineering from University of Pune, India. In addition, he holds a
California Real Estate Broker’s license and is a member of ULI,
NAIOP and the Cornell Real Estate Council.