The Capitalization Rate of Commercial Properties and Market Returns †

The capitalization (cap) rate as used in the real estate literature refers to the ratio of net operating income to property value. This rate has a particularly important role in property valuation, because the income capitalization method converts the expected income stream from commercial property into an estimate of asset value by dividing the net operating income stream by the capitalization rate (Brueggeman and Fisher, 1993: 438). The cap rate bears a close relation to the weighted average cost of capital (WACC) as defined in the corporate finance literature (Copeland and Weston, 1988). The WACC is the rate of discount that reflects the average costs of debt and equity capital employed by a firm. Discounting the cash flows from corporate assets at the WACC reveals the value of the firm. The relation between the WACC and firm valuation has extensive theoretical underpinnings extending from the firm valuation work of Modigliani and Miller (1958). Sharpe’s (1964) development of the capital asset pricing model (CAPM) revolutionized stock portfolio theory and provided a widely accepted method to empirically estimate the cost of equity, which as this paper shows is an embedded component in the cap rate. Recent empirical work in the real estate literature seeks to explain the cap rate relative to other rates and macroeconomic factors (Froland, 1987; Evans, 1990). Ambrose and Nourse (1993) develop an investment approach based on the WACC; however, they do not incorporate the CAPM in their model. Instead, they rely on the intuitive argument that debt rates on mortgages should be related to government debt rates and that the cap rate should be related to the earnings-price ratio. THE JOURNAL OF REAL ESTATE RESEARCH 1