Cap Rate Variations --- Commercial real estate professionals live and breathe capitalization rates. Every trade publication, market participant, and third-party report relating to real estate quotes cap rates for various markets and properties. But ask a group of real estate professionals to calculate a specific property’s cap rate and you are likely to get a variety of answers — despite the simplicity of the formula. If cap rates are widely used and easily calculated, then why does everyone come up with a different answer?

This article looks at the underlying reasons for cap rates variations, ranging from different uses by market participants to different methods of cap rate extraction. While CCIMs are trained to extract cap rates in a certain way, not all market professionals use the same criteria. Understanding how such variables can affect the cap rate and the value of a property is just as important as developing — and using — a consistent method of cap rate extraction.

Cap Rate Overview
A cap rate in its simplest form is a return on an investment based on the principle of anticipation. Value is the present worth of future benefits. A cap rate attempts to quantify the risk profile of the future benefits. It is calculated by using a non-complex formula, R=I/V, where I is the net operating income and V is the value of the property. In more complex terms, a cap rate measures a single-period, unleveraged rate of return on a real estate investment. By converting income into value, a cap rate expresses the relationship of one year’s income and value. A cap rate’s three main components are net income, property value, and the rate of return. If two of the three variables are known, the unknown variable can be extracted through a simple calculation. Granted, different types of cap rates exist — overall, terminal, equity, mortgage, building, and land — which may cause some confusion among market participants. The overall rate, or OAR, is the cap rate applied to both the land and building and is the most commonly used rate by real estate professionals. A cap rate is essentially a dividend rate, so one could call the mortgage constant a “lender” cap rate and a cash-on-cash an “equity” cap rate. However, in commercial real estate transactions, brokers and investors tend to focus on two cap rates: acquisition and disposition.

Marketplace Misuse?
Common reasons for cap rate variations often come from the income stream and operating expenses used in the rate’s extraction. Failure to consider the likely future income of the property (year one pro forma) does not follow the principal of anticipation. The historical and current operating data is useful when developing a projection of year one data, but should not be used in the extraction of a cap rate when applying it to year one projections. Extracting a cap rate from market data using historical income and applying it to the year one projection of the property being valued will result in an incorrect value opinion.


Real estate is often considered a hedge against inflation due to the ability to increase rents at or above the rate of inflation. In an upward trending market the buyer of a property is expecting next year’s income (year one) to be greater than the trailing year to account for appreciation. Extracting a cap rate from the in-place income (less risk) and applying it to the future income projection (more risk) will overvalue the property.

In addition, the same method of income and expense projections used to extract a cap rate from the market should be used to value a property. Using a different income stream from a comparable property (not stabilized, no third-party management, no replacement reserves, under market operating expenses, and such) will result in a different risk profile of the income stream and corresponding cap rate.

Many market participants do not include replacement reserves as an above-the-line (net income) expense when developing cash flow projections. Replacement reserves for future capital expenditures are market specific. Including or excluding replacement reserves will have an impact on the cap rate extracted from the sales transaction, but not the value of the property. Neither method is incorrect as long as the same method is applied to the property being valued and the sale comparable. If the sale comparable does not include replacement reserves in its pro forma projection, and the subject does include replacement reserves in its year one projection, the market extracted cap rate must be adjusted downward to reflect a riskier income profile of the sales transaction comp when compared to the asset being valued. If no adjustment to the cap rate is made, then the subject will be undervalued due to differing risk profiles. Properties that do not include replacement reserves have increased risk due to the lack of a sinking fund for future capital expenditures.  In other words, the NOI needs to be “clean”: One cannot compare an NOI with deducted reserves above the line with one deducted below the line.

Owner-Managed Properties
Another common misconception concerns third-party management fees. Small properties or ownership entities that have a built-in management company often do not include third-party management fees in their pro forma. Having a third-party management company manage an asset may reduce the operational risk of the property and can result in a lower risk profile of the future income stream. A lower risk profile results in a lower cap rate. Table 1 shows how excluding third-party management fees impact the year one return and risk profile. 

As Table 1 reveals, a 7.5 percent cap rate is appropriate if the property pro forma includes expenses for third-party management fees. Based on the projected NOI and market extracted cap rate, a value of $1,666,667 is indicated. If the same property does not include management fees in the pro forma projection, the value of the property is unchanged, with the risk adjusted cap rate increasing to 8.1 percent.

This is why it is necessary for potential buyers to reconstruct NOI to include such items as property management. The increase in the cap rate is to account for increased risk due to the lack of professional third-party management. Additionally, real estate is considered to be a passive investment with the opportunity cost of the owner’s time requiring compensation through a management fee or higher rate of return. 

Expense Comparison in Sale Comparables
Comparing the operating expenses used in a sale comparable to extract a cap rate is a good indicator if the cap rate is market driven. A sale comparable that is owner managed and does not include reserves will have below-market expenses on a per unit comparison (percentage of effective gross income, per square foot, per unit, and such). A comparison of the expenses from the sale comparables to industry standards used in the local market will allow the analyst to adjust the extracted cap rate accordingly and then apply the revised cap rate to the property being valued. If a data set of comparable sales indicates a wide range of cap rates, then it is likely that one or more of the sales is not based on market derived income and expenses.

Impact on Property Valuation
Table 2 shows how various income and expense projections can impact the extracted cap rate and the asset’s value indication. For purposes of this analysis, only one variable has been adjusted. In actuality, a sale comparable will often have multiple variables that need to be adjusted in order to accurately extract a cap rate.

The Table 2 example reports a market extracted cap rate that ranges from 5.70 percent, based on the asking price commonly quoted by brokers in third-party surveys for marketing purposes, to 6.48 percent, based on using year one projections. All of the extracted cap rates are correctly calculated. However, the difference in rates is attributed to varying risk profiles of the income stream. Based on the provided example, adjusting just one variable can result in a 13.68 percent difference in value. If additional variables are included, the spread between the cap rates can widen and further magnify the miscalculation.

While there is a simple formula for finding the cap rate, there is no standard method for cap rate extraction. Various markets and market participants apply different income and expenses projections when calculating NOI. However, a standard method for extracting a cap rate from market data is critical to properly value a property. Not all NOIs have the same risk profile. A property that includes third-party management and replacement reserves will have less net income, a lower risk profile due to adequate third-party management, and appropriate funds for future capital expenditures — and result in a lower cap rate. Regardless of the variables included or excluded in the cap rate extraction, if applied consistently to the property being valued, a reliable estimate of value will result.

The Cash Flow Analysis Worksheet used in CCIM classes shows reserves below the NOI line, so CCIMs need to pay careful attention to the components of NOI and make sure that the NOIs of comparable properties are calculated in a consistent manner. A thoughtful CCIM will re-construct NOI to be consistent and will know enough about cap rates in the marketplace and expense ratios, vacancy, and market rents to sense if adjustments are necessary to an advertised NOI.

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Investor group from China acquires 12 courses from National Golf Management

Sun News - The investor group from China established as Founders Group International (FGI) has become the largest owner and operator of golf courses in the Myrtle Beach market.  The company has acquired the majority of National Golf Management’s assets, giving it a vested interest in 22 courses (423 holes) in the Myrtle Beach golf market.  National Golf Management had been the largest owner/operator in the market with the 12 courses that it both owned and operated and an additional four run through management contracts and/or leases.  The courses acquired in the transaction stretch from Pawleys Island to Georgetown. They are: Long Bay Club; Pine Lakes Country Club; Grande Dunes Resort Course; River Club; Pawley’s Plantation; Willbrook Plantation; Litchfield Country Club; the King’s North, SouthCreek and West courses at Myrtle Beach National Golf Club; and the Palmetto and PineHills courses at Myrtlewood Golf Club.

The deal does not include National Golf Management’s management contracts for Farmstead Golf Links, Meadowlands Golf Club, Arcadian Shores Golf Club and Blackmoor Golf Club.  NGM was formed in March 2012 as a merger of most of the golf-related assets of Myrtle Beach National Co. and Burroughs & Chapin Golf Management. Two courses it had been managing – Wild Wing Plantation and Tradition Club – were purchased by Founders Group in the past two weeks and a management contract with Wachesaw Planatation East ended in January and wasn’t renewed.  Grande Dunes, Pawleys Plantation and the King’s North Course are among the area’s upscale layouts, while Pine Lakes opened in 1927, is the oldest course on the Strand and rivals The Dunes Golf and Beach Club as the area’s most iconic course.  Those courses are added to the layouts the company has already purchased in the area: TPC Myrtle Beach, Aberdeen Country Club, Burning Ridge, Colonial Charters, Founders Club at Pawleys Island, Indian Wells Golf Club, River Hills Golf & Country Club, International World Tour Golf Links, Tradition Club and Wild Wing Plantation.

The acquisition also includes National Golf Management’s call center known as “Tee Time Central,” its golf package operations known as “Ambassador Golf” and “Myrtle Beach Golf Trips,” the Myrtle Beach area’s most visited golf-related websites including,,, and National Golf Management’s local membership program known as “Prime Times.”  Founders Group International’s Chinese parent company, Yiqian Funding, is primarily owned by Chinese investor Dan Liu and New York immigration attorney and FGI president Nick Dou.  According to a press release, day-to-day management responsibilities will be spread among key executives for the organization. No changes are planned for current operational employees at each facility.

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