![]() If you start with the simplest one, if I bought something that has a million dollars in let’s say prospective NOI, and I’m buying it for $10 million, we’d say the cap rate– you and I would both say the cap rate on that purchase was 10. PETER LINNEMAN: Well, I think it’s very simple because it, as you describe, picks up two different things. How can a student reconcile these two things in their head– the property value and the cap rate? And so this somewhat circular nature, I think, can be confusing for students. And it can be a little bit tricky with cap rates because cap rates are at the same time the determinant of a property’s value but also simply mathematically the result of a property’s value given a certain assumed NOI stream. In this case, a full DCF analysis is needed.īRUCE KIRSCH: We start to talk about capitalization rates, which everybody abbreviates as cap rates. If a property does not meet these “stabilized” criteria, using the Gordon Model will result in unreasonable valuation estimates (negative or infinity). The growth rate must be smaller than the discount rate (r) when applying the Gordon Model. Students can use the Gordon Model to estimate value if the projected NOI is expected to grow at the same rate (g) per year indefinitely. The Gordon Model helps approximate the DCF value of a property that has a constant expected NOI growth rate in perpetuity. If a building sells for more than its replacement cost, an investor might be better off developing a new building instead of buying the existing one, and vice versa. Replacement cost gives an indication of what it would cost to build the same building today and can sometimes be used as an additional tool to estimate the value of a property. Determining the stabilized NOI of a property is a subjective matter and can result in very different valuations for the same property. While cap rates are a good “quick and dirty” tool for pricing real estate assets, students should be aware that cap rates can only be applied when using stable NOI estimates. ![]() Market cap rates change as the market perception of risk, cash flow, or growth changes. Cap rates are determined by the market as the expected yield an owner should get on a stabilized income-producing property given a certain risk level (similar to valuation of coupon-paying bonds). A cap rate is defined as stabilized NOI divided by property value (stabilized NOI/property value = Cap Rate). Cap rates are generally used in real estate valuation analysis and are the inverse of a traditional corporate earnings multiple. ![]()
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