Market Extraction Method – Understanding Cap Rates from Comps

One of the most direct ways to estimate a capitalization rate is by using the Market Extraction Method.  This approach involves analyzing recent sales of comparable properties, then deriving the cap rate from that comp set.

Something to keep in mind when using this method is that to get meaningful results, the comps should reflect adequate financial data which usually can be found in the offering memorandum that was created for the listing.  Additionally, if necessary, each comparable sale should be analyzed further to see if they represent typical market standards. 

Example:

The subject property is a 20-unit apartment complex that was built in 1970 and contains 20% 1-bedroom units and 80% 2-bedroom units.  The comparable data set represents the most similar and recent sales of comparable properties in the subject’s area.  The in-place cap rates range from 3.56% to 5.61%, with an average of 4.30%.  The proforma cap rates range from 5.19% to 6.80%, with an average of 5.65%. 

Comp 4 is the outlier and upon further review, this comp does not account for a vacancy factor and only a 15% expense ratio, both of which are not consistent with typical market standards.  For an apples-to-apples comparison, a 5% vacancy factor and 35% expense ratio were applied to Comp 4 and now the in-place cap rate is 3.96% and the proforma cap rate is 5.32%.  Now the comp set indicates that the in-place cap rates range from 3.56% to 4.07%, with an average of 3.89%.  The proforma cap rates range from 5.19% to 5.32%, with an average of 5.28%. 

With this adjustment, the comps provide a tighter range and now depending on the subject’s rental upside, selecting the appropriate cap rate should be well supported with these comps.  This method is simple in theory and can provide credible results with some due diligence.