Chapter 9 | The Use and Selection of Cap Rates


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The value of a property can frequently be estimated using cap rates, replacement cost, and the Gordon Model, all far simpler methods than discounted cash flow (DCF) analysis.


Cap rates are generally used in real estate valuation analysis and are the inverse of a traditional corporate earnings multiple.  A cap rate is defined as stabilized NOI divided by property value (stabilized NOI/property value = Cap Rate).  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).  Market cap rates change as the market perception of risk, cash flow, or growth changes.  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.  Determining the stabilized NOI of a property is a subjective matter and can result in very different valuations for the same property.

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.  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.

The Gordon Model [NOI/(r-g)] helps approximate the DCF value of a property that has a constant expected NOI growth rate in perpetuity.  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 growth rate must be smaller than the discount rate (r) when applying the Gordon Model.  If a property does not meet these “stabilized” criteria, using the Gordon Model will result in unreasonable valuation estimates (negative or infinity).  In this case, a full DCF analysis is needed.


These are the types of questions you’ll be able to answer after studying the full chapter.

1. What is the difference between a cap rate and a multiple?

2. Calculate the value of a building that has a $1.2 million stabilized NOI at an 8% cap rate.

3. What is the difference between a cap rate and a multiple?

4. A building has a $3 million stabilized NOI and was recently sold at $21.6 million. At what cap rate was the building sold? How much risk premium does this building have over a 10-year Treasury note that yields 2.6%?

5.  Does a seller prefer higher or lower cap rates?

6. What is replacement cost? When is it used?

7. When should the Gordon Model be used in a property pro forma?

Audio Interviews

Cap rates vs. cash-on-cash return (7:49)


Cap rate spreads (5:35)


Future cap rate selection (8:33)


Cap rate comparisons across properties (3:36)


The ideal split of cash flow: operating vs. residual (4:57)

Key Terms

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Estimates the value of a property by multiplying next year’s “stabilized” NOI by the price-to-NOI multiple for which comparable properties are selling today. The price-to-NOI multiple is the reciprocal of the cap rate.

A property’s “stabilized” NOI divided by its value (purchase price, either actual or anticipated), expressed as a percentage. The cap rate is the inverse (reciprocal) of the income multiple.

A property at full occupancy, except for an expected “systemic” level of vacancy, whose NOI is flat or growing relatively smoothly year-over-year. For instance, a 100-unit apartment building with 4% yearly vacancy and 2.5% yearly NOI growth.

NOI for a stabilized property (a property at full occupancy, except for an expected “systemic” level of vacancy, where the NOI is flat or growing relatively smoothly year-over-year, e.g., a 100-unit apartment building with 4% yearly vacancy and 2.5% yearly NOI growth).

An approximate “normal” level of capital reserves for an operating property.

Unlevered cash flow where the adjustment to NOI is the deduction of normal reserves.

The hypothetical amount it would take to acquire the land and construct an existing property today, including the cost of the LCs and TIs needed to attain the exact same tenant profile.

A hypothetical never-ending cash flow stream.

Converts perpetuity DCF analysis for a cash stream growing at a constant rate into a simple cap rate approximation by dividing stabilized NOI by the difference between the property’s discount rate (r) and its NOI growth rate (g).

The required expected annual rate of return that is used to reduce future projected cash flows to their present values.  The discount rate for a property is theoretically composed of four factors: the long-term risk-free rate (approximated by the yield on a 10-year U.S. Treasury bond), expected economy-wide inflation, the risk premium associated with unexpected outcomes in the property’s NOI, and the risk premium associated with the property’s illiquidity relative to a 10-year Treasury bond.

The margin of property cap rates above the 10-year U.S. Treasury. The spread increases when investors seek safety in government bonds, driving their prices up and yields down, and it decreases when investors perceive a decline in risk associated with real estate cash flows, causing them to move from government bonds into real estate positions.

A proxy for property income yields after normalized reserves are deducted for tenant improvements, leasing commissions, and capital expenditures.

Chapter Headings

  • Basic Cap Rate Valuation
  • Not Everyone Agrees
  • Replacement Cost
  • Gordon Model: Simple Cap Rate Estimation
  • Let Your Common Sense Prevail
  • Market Change
  • Responding to the Market
  • A Look at the Past
  • Contractual Information

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