User:KTrimble/Sandbox/Capitalization Rate Sandbox

I am currently using my sandbox as a work area for a proposed rewrite of the article on Capitalization Rate.

Please make any comments or proposed changes in the discussion page of this sandbox--thanks 72.161.6.241 (talk) 17:39, 6 April 2008 (UTC)

A capitalization rate (or "cap rate") is a type of income rate which expresses the relationship between the economic benefits of an asset or a property (or a component thereof) through one specific period of time and its value. The economic benefit is usually measured as the market value of the benefits of the asset (typically measured as the income which would accrue to or be imputed to the asset or to its ownership) over one specific period, with the period usually being associated with the date of value. The value of the asset or property is usually a market value of some sort, but not always.

The capitalization rate is not the same as a yield rate or a discount rate which is the rate of return on capital, usually expressed as a compound percentage rate, which reflects all expected asset benefits through the term of ownership including the proceeds of sale at the termination of the ownership. Examples of yield rates include interest rates and internal rates of return (IRR). A capitalization rate, in contrast, is an observed relationship where the income is either reported or estimated for a specific period and the value is observed as a price in a sale event or otherwise estimated.

The capitalization rate is usually expressed as a percentage where

Capitalization Rate = economic benefit / value (replace with a formula notation)

The capitalization rate is the inverse or reciprocal of a corresponding multiplier. For example, the ownership capitalization rate of a stock company is the inverse of its Price/Earnings Multiple or [P/E ratio].

Capitalization rates are most often used in the process of valuation or appraisal, typically within the context of an Income Capitalization Approach. However, they are also less commonly used as measures of investment performance where the current income of an asset is related to its historical cost, book value, or investment value pursuant to possibly non-market investment objectives for purposes of facilitating comparison of investment assets.

For any given asset, there can be several different capitalization rates, for example,

• Value is a concept which assumes a measurement as of a point in time. A capitalization rate can be a prospective capitalization rate, where the benefits are measured through the period immediately before the date of value, or a retrospective capitalization rate, where the benefits are measured through the period immediately following the date of value.

• A capitalization rate can express the relationship between income and value of an entire asset (or an asset class or a collection of assets) in which the rate is called an Overall Capitalization Rate, or a component of the asset, whether a physical component, a financial component, or an income component. An important property of capitalization rates is that the overall capitalization rate is equal to the weighted average of the capitalization rates of its constituent components. This property of capitalization rates allows the derivation of capitalization rates for one asset type from the known capitalization rates of other assets using the band of investment technique.

Use in Valuation and Appraisal

Capitalization rates are most commonly associated with the Direct Capitalization methods of the Income Capitalization Approach of the appraisal process, being most common in Real Estate Appraisal.

The Income, Value, and Rate Identity

A capitalization rate is like other rates which measure a rate of change as a proportion of a quantity. The three components in the definition of any rate are the rate, the quantity, and the quantity of change in a period of time. Knowledge of any two components will allow calculation of the third component, as follows:

Capitalization Rate = Income / Value

Income = Value * Capitalization Rate

Value = Income / Capitalization Rate

The Basic Process of Direct Capitalization

In Direct Capitalization, the capitalization rate is considered a type of Unit of Comparision which can facilitate the comparison of sale properties with a subject of the valuation. The basic process is as follows:

• Sales of properties considered similar to the subject property are observed in the market where the income of each sale property is known (or can be estimated).
• Dividing the income of each sale property by its sale price produces the overall capitalization rate of that sale property at the time it sold. Each capitalization rate observed in the market is considered an indication of the capitalization rate which will represent the relationship between the income and the value of the subject property.
• The indications of capitalization rates are reconciled. If properties considered equivalently desirable in the market to a subject property are observed to sell in the market with reasonably consistent capitalization rates, then the appraiser or valuer can draw a conclusion (through inductive reasoning) of a particular capitalization rate based on the observed sales that represents the relationship between the subject property's income and its value.
• If the income of the subject property is known or can be estimated, it can then be divided by the concluded market-indicated capitalization rate to obtain an indication of the value of the property.

Real Estate Example

The use of capitalization rates is most common in the valuation of real estate.

Consider a subject property which generated an income of $10,000.00 over the past year. (Assume that the property is rented at market rates, that its expenses are not irregularly variable, and ignore vacancies for purposes of illustration).

The appraiser observes three sales. Sale No. 1 is physically identical to the subject property, is located across the street from the subject, and sold last week for $100,000.00. It also generated $10,000.00 in the year prior to its sale. Sale No. 2 is very similar to the subject property, but larger and located on the next block, and sold two months ago for $125,000.00. It generated $12,500.00 in the year prior to its sale. Sale No. 3 is the same property type, but considerably larger and located across the river in a neighboring town, and sold six months ago for $450,000.00. The appraiser did not know its income, but was able to confirm the property's rent and estimated its expenses and calculated that the property generated $44,000.00 in the year prior to the sale.

These three sales demonstrate overall capitalization rates as follows:

Sale No. 1: $100,000.00 sales price / $10,000.00 income = 10.0 % overall capitalization rate

Sale No. 2: $125,000.00 sales price / $12,500.00 income = 10.0 % overall capitalization rate

Sale No. 3: $450,000.00 sales price / $44,000.00 estimated income = 9.77 % overall capitalization rate

Through the process of reconciliation, the appraiser notes that Sale No. 3 is the least similar to the subject property, occurred several months ago (reflecting market conditions at that time, which may not be indicative of values at the current time), and may reflect a slightly different market than the subject. The appraiser concludes that Sale No. 1, being physically identical, co-located, and a recent sale, is the best indicator of value and is supported by Sale No. 2. From this data, the appraiser concludes that the capitalization rate which represents the market's judgement of the relationship between the subject's income and its value is 10.0%.

Dividing the subject's income of $10,000.00 by the market indicated capitalization rate of 10% produces an indication of value for the subject property of $ 100,000.00. ($10,000 / 0.100 = $100,000)

Business Valuation Example

The subject is a readily marketable 300,000 share block of stock in a regulated public utility representing a substantial proportion of the total ownership, but not capable of forcing liquidation or any change in management. Being publicly regulated, the firm's pricing, return on assets, and all other important operating characteristics are closely regulated and closely similar to all other public utilities in the state.

The normal daily volume of the firm's stock on all markets averages around 5,000 shares per day and the stock closed today (the last recorded trade of the day was) at $60.50 per share, so the sales of shares of the subject firm's stock represent small lots that might not be clearly indicative of the value of the subject block of stock. There have been no sales of similarly sized blocks of stock in the subject firm for over a year. However, the appraiser has obtained reports of seven other similarly sized blocks of stock of other public utilities with similar debt structures, operating ratios, etc. within the past month that have sold with P/E ratios of 20.0, 21.2, 20.6, 19.8, 20.1, 20.9, and 20.4. Paid dividends disperse all EBITDA to shareholders for all seven sales. Dividing dividends by per share sales prices produce capitalization rates of 5.0%, 4.71%, 4.85%, 5.10%, 4.98%, 4.78%, and 4.90%. The appraiser concludes the capitalization rate applicable to the subject stock should be 5.0%. The subject's stock received $3.00 in dividends per share in the previous year and the dividend growth is very similar to other public utilities.

Dividing the subject stock dividend of $3.00 per share by the inferred capitalization rate of 5.0 % suggests a per share value of $60.00. Multiplying by the size of the portfolio of 300,000 shares suggests a value for the block of stock of $18,000,000.00.