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INDUSTRY PROFILE
Real estate in United States is one of the largest markets in the world. In fact, it is so significant to world
economic activity that the availability of easy money and the subsequent Housing Bubble triggered the Sub-
Prime Crisis and eventually the global Financial Crisis of 2008 - 2009 that brought the world's economy to its
knees. The US real estate market is divided into 2 sectors: commercial real estate and residential real estate.
Most discussion tends to focus on residential real estate (i.e. houses), but commercial real estate is also a
critical sector of the economy, and is made up of offices, shopping malls, factories, warehouses and other
commercial buildings.
In order to be successful in real estate investment, an investor needs to understand house price trends, assess
the condition and value of the investment property, and secure a suitable mortgage or other form of real
estate finance. The US real estate industry has been experiencing wonderful growth due to the relatively
steady good economy. In 2006, some markets had major gains in occupied space, others saw record sales
transactions. The market has begun to tighten, developers remained cautious possibly eye toward the future,
particularly predictions of escalating rental rates.
Appraisers
Appraisers can be a part of every stage of the property development process. Appraisers are primarily
responsible for valuation of the project. They estimate the market value of the property and typically prepare
a formal document called appraisal. Appraisal may be necessary when a developer transfers ownership, seeks
financing and credit, resolves tax matters, and establishes just compensation in condemnation proceedings.
Appraisers can also evaluate a project as input to market studies and feasibility studies. Some of the familiar
names in the US Real Estate markets include CB Richard Ellis, Cushman and Wakefield and Grubb and
Ellis.
Property managers
Property managers focus on the day operation of the asset. Property managers carry responsibility for
all respects of the physical space in accordance with the asset manager's plan. The responsibilities of a
property manager include:
• Marketing and leasing
• Maintenance and repair
• Tenant relations including rent collection
• Insurance
• Accounting
• Human resource management
• Providing timely information to the asset manager about events affecting the property.
Some of the major property managers include Trammel Crow Company and Grubb and Ellis Company.
Lenders
A) Construction Lenders are usually commercial banks, which are responsible for financial during
project construction and for seeing that the developer completes the project within the budget and according
to the specifications.
B) Permanent lenders seek to originate safe loans generating the maximum possible return. The
market value of the completed project is very critical in that it serves as the primary collateral for the loan.
COMPANY PROFILE
ZENTA KNOWLEDGE SERVICES PVT. LTD.,
About Zenta:
Zenta which is founded in 2001 is a world-class knowledge process outsourcing (KPO) and business process
outsourcing (BPO) and Company, offering a full range of back-office, voice and on-site support solutions
such as Credit Card Servicing, Consumer Lending Servicing, Accounts Receivable Management, Mortgage
Servicing and Real Estate Capital Market Analytics. The Company serves in the area of Consumer Credit
services, Insurance and Financial Services, and Commercial and Residential Real Estate services. With
4,500+ employees worldwide, Zenta has operations in six locations across three continents. Zenta is a
preferred employer in India. Zenta pioneered the concept of developing and delivering higher level offshore
solutions for the real estate industry. The unique onshore/offshore approach combines US domain expertise,
a proven process migration methodology and a large team of highly trained offshore finance professional.
Zenta allows the clients to focus on their core business by utilizing its cost effective resources and scalable
platform to execute non- core activities.
Zenta Solutions
From origination and throughout the customer lifecycle, Zenta delivers deep, end-to-end servicing solutions.
Zenta's specialized focus on the financial services industry and our management expertise and experience,
are the reasons we have been chosen to provide high-end business processing for some of the world's most
prestigious banks and financial institutions. Instead of coordinating multiple vendors, Zenta's complete
solution set makes it possible for clients to work with one company only - providing a single source for all
their business processing needs. Zenta's end-to-end solutions include Credit card servicing and Commercial
Realty Services, Residential Realty Services and Account Receivables management, Healthcare Revenue
Cycle Management and Residential Mortgage Services.
Zenta’s executive, client facing and management teams are based in the U.S. and are comprised of leaders
with deep and broad industry expertise from top Fortune 1000 companies. They deliver the depth of
experience necessary to build long-term, strategic relationships with our clients and provide easy access to
Zenta's decision-makers. In addition, an experienced delivery team has extensive expertise in operating
global delivery centers while adhering to the highest industry and quality standards.
Zenta believes in long-term partnerships - but with flexible engagement models. Put simply, we partner with
clients to transform the way they do business. As the global operating model gains momentum, we help
clients meet their business challenges by designing and implementing complex solutions that deliver rapid
and enduring savings, allow clients to quickly introduce new products or services, augment highly skilled
internal resources and minimize large-scale investments. We believe these accomplishments will be achieved
through the innovative ways in which data is captured, collated, analyzed and disseminated.
Our proven ability to scale rapidly, both in volume and skill sets, enables us to create high-impact programs
for our clients. We engage with clients at the early stages of their offshoring program to develop an offshore
"roadmap" that best meets their objectives. Furthermore, we build flexible client relationships and have
experience working on a variety of engagement models.
RESEARCH METHODOLOGY
The purpose of this study is to facilitate the company to value the property in various states of US
Real Estate market using the capitalization rate which in turn enables the company to analyse and
recommend investment strategies for clients such as lending institution, bankers or owners etc through a risk
return analysis of the income streams of different commercial and Real estate properties.
SCOPE OF THE STUDY
• The project seeks to study the various factors to be considered while estimating the capitalization rate.
• To understand the most relevant and reliable methodology for income producing properties.
• To conclude a market value for some subject property in US real estate market.
PRIMARY OBJECTIVES
• To scrutinize the vital factors which affects the capitalization rate of the property and to find out the
importance of each factor.
SECONDARY OBJECTIVES
• To study the impact of property type in determining capitalization rate.
• To determine the effect of location in Real estate market.
STUDY METHOD
Description study method is chosen for the study because of the vast amount of data available in
different books, magazine and websites relating to US real estate. The focussed study of the data can give
good insight into factors influencing capitalization rate.
DATA COLLECTION
For the purpose of the study, secondary data was collected through,
The materials available about US real estate in various websites like realestatejournal.com,
realtyrates.com, bloomberg.com.
The materials maintained in the organization about the properties.
Research publication of other institutes and organization like REIS, PULASKI, CBRE.
REVIEW OF LITERATURE
LITERATURE REVIEW
Sirmans and Webb (1978, 1980) and Ricks (1969) used the ACLI data source. They estimated
imputed equity yields on the investments by hypothesizing average holding periods with no price
appreciation and imputing tax rates. They relate the yield and its variance to alternative investments by using
only the cap rate.
Nourse (1987) uses the REIS data source to estimate the impact of change in capitalization rate for
real estate. His model, however does not take into account the potential variation driven by property types.
Evans (1990) used ACLI data source to estimate the time-series properties for capitalization rates. His
study focuses on comparing the stochastic nature of the stock market earnings/price ratio with real estate
capitalization rate.
Froland (1987) uses the ACLI data source to explain variation in capitalization rate and the
interaction of those rates with the capital market. Froland finds that the capitalization rate is a function of the
mortgage contract rate, the spread between Treasury bills and bonds and the corporate earning price ratio.
However his study has several significant problems like the impact of variation is not considered does not
specify the relationship between the capitalization rate and the independent variables and the interpretation of
his correlation coefficients is weakened by autocorrelation present in the dataset.
Guntermann and Smith (1987) derived estimates of equity rates and costs of capital for property
REITs, mortgage REITs, and homebuilders/developers. While operating properties and REITs had a before-
tax cost of capital of 16.6%, homebuilders/ developers’ cost of capital was substantially greater at 34.9%.
Their study concluded that the data sources and procedures permit the estimation of cost of capital and equity
rates with satisfactory precision and reliability for the majority of investment or appraisal applications.
Froland (1987) compared cap rate movements with competitive yields in the asset
trading markets using quarterly cap rates for apartments, retail, office, and industrial
properties for the first quarter of 1970 through the second quarter of 1986. He found
particularly strong correlations of the cap rate with mortgage rates, ten-year bond rates, and
the earnings/price ratio. In addition, inflationary expectations as measured by the Treasury
bond-bill spread were inversely related to cap rates. Froland also reported negative
correlations between cap rates and indicators of economic cycles, including capacity
utilization, national vacancy rate, and the percentage change in real GNP. Using a stepwise
regression approach, between 86% and 95% of the variation in cap rates was explained by the
mortgage rate, the eight-quarter bond-bill spread, and the price earnings ratio. Froland’s
empirical results were not bound through a theoretical framework and no tests or corrections
for autocorrelation appeared in the study.
A study by Evans (1990) noted the sensitivity of the multifamily and nonresidential real
estate cap rates to the earnings/price ratio in the stock market. This study of quarterly cap
rates for 1966–1988 reported a strong positive relation of real estate cap rates lagging the
earnings/price ratio by one period. Although short of statistical significance, a somewhat
lesser positive correlation occurred in the same quarter and a negative correlation occurred in
the second quarter. Evans concluded that these results were not consistent with the theory that
real estate markets are information efficient.
Ambrose and Nourse (1993) examined mean quarterly capitalization rates for
commercial/retail, office buildings, commercial services, industrial, and hotel properties for
1966 through 1988. The theoretical base for their study is the traditional WACC model that
has been used so extensively in the finance literature. Their empirical model related cap rates
to a local variable, the spread between long-term and short-term Government bond rates, the
earnings/price ratio of the S&P 500, and debt-to-equity components. The debt-to-equity
components were estimated from the average loan-to value and property mortgage costs.
Using seemingly unrelated regression (SUR), they reported that cap rates were not closely
tied to either the S&P 500 or the bond risk premium spread. Using a cross-sectional/time-
series regression approach, they found that Weighted cost of debt of .98, not significantly
different from one. Also, the return on equity was estimated at 4.85% and was statistically
different from zero. The intercept and slope coefficients were found to vary significantly by
property type; however, the panel data regression did not permit separate slope coefficients
by area.
A market cap rate is determined by evaluating the financial data of similar properties
which have recently sold in a specific market. It provides a more reliable estimate of value
than a market Gross Rent Multiplier since the cap rate calculation utilizes more of a
property's financial detail. The GRM calculation only considers a property's selling price and
gross rents. The Cap Rate calculation incorporates a property's selling price, gross rents, non
rental income, vacancy amount and operating expenses.
If we have a seller and an interested buyer for particular piece of income producing
property, the seller is trying to get the highest price for the property or sell at the lowest cap
rate possible. The buyer is trying to purchase the property at the lowest price possible which
translates into a higher cap rate. The lower the selling price the higher the cap rate. The
higher the selling price, the lower is the cap rate. In summary, from an investor's or buyer's
perspective, the higher the cap rate, the better. Investors expect a larger return when investing
in high risk income properties.
The Cap rate may vary in different areas of a city for many reasons such as
desirability of location, level of crime and general condition of an area. You would expect
lower capitalization rates in newer or more desirable areas of city and higher cap rates in less
desirable areas to compensate for the added risk. In a real estate market where net operating
incomes are increasing and cap rates are declining over time for a given type of investment
property such as office buildings, values will be generally increasing. If net operating income
is decreasing and capitalization rates are increasing over time in a given market place,
property values will be declining.
The cap rate (R) equals (expected) net operating income NOI1 divided by the value
of the property (V) as follows (Ellwood, 1970),
The property value for determining the cap rate is based on the sales price in a
competitive market commonly called the market value. Brueggeman and Fisher (1993) noted
that the cap rate is not an internal rate of return on investment (IRR) because it does not
consider changes in projected future income (or changes in the value of a property over time
because of changes in the income stream). If the income stream is expected to grow at a
constant growth rate (g) into the foreseeable future, Brueggeman and Fisher (1993) show that
the value of a property is estimated as the present value of a perpetual stream of future net
operating income cash flows using discount rate r:
Rearranging equation, the cap rate equals the total required return on the property less the
expected growth rate as given:
The capitalization rate differs from property to property. It ranges from high in Retail
property to low in hotel property. The following table provides the capitalization rate for the
various property types from 2005 – 2010.
• Property Type
The Property type is the category to which it belongs. The various types of properties
are Retail, Office, Mixed Use, Hotel, Multi-family, Self storage and Industrial
properties.
• Location
Location means the state in which the subject property is situated.
• Loan To Value
Loan to value is the portion of the amount borrowed compared to the cost or value of
the property purchased. A higher LTV ratio means higher leverage and thus greater
risk.
• Market
Market means a city/region in which the subject property is located and included the
geographic location, economy, employment trends etc. of the region.
• Mortgage Constant
The relationship between annual mortgage loan requirement and the initial mortgage
loan principal expressed as a decimal or percentage, for level payment mortgage loan.
• Lease Term
Lease term is the term during which the tenant agrees to stay in the property by
entering into a lease agreement with the landlord.
• Interest rate
Interest rate is the percentage of a sum of money charges for its use. It is the return on
an investment.
• Inflation
Inflation is the loss in purchasing power of money and increase in the general price
level. Generally measured by the consumer price index published by Bureau of Labor
Statistics
• Number of Tenants
Number of tenants occupied in the property is the number of tenants. It may be single
tenant for the office property and multi-tenant for the retail property.
• Discount Rate
Discount rate is rate of interest charged by Federal Reserve System to banks who
borrow money from the Federal Reserve. An increase in the rate not only discourages
from borrowing but also serves as a signal to money market that the interest rates are
probably going to increase. Accordingly, interest rates charged by banks to customers
usually increases as a result of increase in discount rate. The term is also used to
explain the compound interest rate used in the approach to value to convert expected
future cash flows into present value.
DATA ANALYSIS AND INPERPRETATION
Descriptive analysis:
All the above factors that affect the Capitalization Rate are used in the Descriptive Statistics.
Descriptive Statistics
Mean Std. Deviation N
CORRELATION ANALYSIS
r= n∑xy - ∑x * ∑y
The correlation coefficient r, a value between +1 and -1, expresses the degree of
association between X and Y.
In order to scrutinize the vital factors which affect the capitalization rate of the property, in
this study we take Capitalization Rate as a dependent Variable and all the other factors as a
independent variable.
PROPERTY TYPE
2.3
1.8
1.3
0.8
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
5.5
4.5
Quantified Location
3.5
2.5
1.5
0.5
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
70
50
40
30
20
10
0
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
20
15
Lease Term
10
0
0.05 0.06 0.07 0.08 0.09 0.1
CapRate
0.08
0.075
0.07
Interest Rate
0.065
0.06
0.055
0.05
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
0.029
0.027
Inflation
0.025
0.023
0.021
0.019
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
0.12
0.11
Discount rate
0.1
0.09
0.08
0.07
0.06
0.05
0.05 0.06 0.07 0.08 0.09 0.1
CapRate
0.09
Mortgage Constant
0.085
0.08
0.075
0.07
0.065
0.06
0.055
0.05
0.05 0.06 0.07 0.08 0.09 0.1
CapRate
0.85
0.8
0.75
0.7
LTV
0.65
0.6
0.55
0.5
0.45
0.4
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
2.2
1.8
DSCR
1.6
1.4
1.2
1
0.05 0.06 0.07 0.08 0.09 0.1
Cap Rate
Multiple linear regressions are used to predict the variance in an interval dependent,
based on linear combinations of independent variables. Multiple regression can establish that
a set of independent variables explains a proportion of the variance in a dependent variable at
a significant level (through a significance test of R2), and can establish the relative predictive
importance of the independent variables. One can test the significance of difference of two
R2's to determine if adding an independent variable to the model helps significantly. Using
hierarchical regression, one can see how most variance in the dependent can be explained by
one or a set of new independent variables, over and above that explained by an earlier set.
The estimates (b coefficients and constant) can be used to construct a prediction equation and
generate predicted scores on a variable for further analysis.
The multiple regression equation takes the form y = b1x1 + b2x2 + ... + bnxn + c. The b's
are the regression coefficients, representing the amount the dependent variable y changes
when the corresponding independent changes one unit. The c is the constant, where the
regression line intercepts the y axis, representing the amount the dependent y will be when all
the independent variables are 0. Associated with multiple regression is R2, multiple
correlation, which is the percent of variance in the dependent variable, explained collectively
by all of the independent variables. Multiple regression shares all the assumptions of
correlation: linearity of relationships, the same level of relationship throughout the range of
the independent variable, interval or near-interval data, absence of outliers, and data whose
range is not truncated. Here,
R2 - coefficient of determination, gives the proportion of the variance of one variable that is
predictable from the other variable.
Standard Error - The standard error of a statistic is the standard deviation of the sampling
distribution of that statistic.
F-Ratio – F-ratio is the test statistic used in analysis of variance to compare the magnitude of
two estimates of the population variance to determine whether the two estimates are
approximately equal.
Significance Level - The probability of a false rejection of the null hypothesis in a statistical
test.
Multiple linear regression analysis was done using SPSS. As discussed earlier only the below
mentioned factors are considered for regression analysyis.
Dependent variable : Capitalization rate
Independent variables : Age of the Property, Interest Rate, Discount Rate and
Mortgage Constant.
Model Summary
Change Statistics
R Adjusted R Std. Error of R Square Sig. F
Model R Square Square the Estimate Change F Change df1 df2 Change
1 .644a .415 .321 .760519% .415 4.428 4 25 .008
a. Predictors: (Constant), Mortgage Constant, Age of the Property, Discount
Date, Interest Rate
R Square = 0.415 (41.5%). The independent variables explain 41.5% of dependent variable
(Capitalization Rate). Significance level is 0.8%
ANOVAb
Sum of
Model Squares df Mean Square F Sig.
1 Regression 10.245 4 2.561 4.428 .008a
Residual 14.460 25 .578
Total 24.705 29
a. Predictors: (Constant), Mortgage Constant, Age of the Property, Discount
Date, Interest Rate
b. Dependent Variable: Cap rate
F – Table value at 0.05% significance level and degrees of freedom (12, 17) = 2.38
As, the F critical value is less than the F statistic (3.38) obtained, the null hypothesis is
rejected.
H0: There is no significant relationship between Capitalization rate and other factors.
H1: There is significant relationship between Capitalization rate and other factors.
The figure shows in the regression plot between the Capitalization Rate and predicted
factors of capitalization rate.
0.1
0.095
0.09
0.085
0.08
0.07
0.065
0.06
0.055
0.05
0.05 0.06 0.07 0.08 0.09 0.1
Predicted Y
REGRESSION EQUATION:
+ 0.0001 * Property type + 0.7037* Interest rate + 0.0718* Equity yield + 0.0000 * As is
value + 0.1451 * Inflation +0.0006 * Lease term + 0.2846 * Discount rate – 0.0001 * Age
of property + 0.3117 * Mortgage constant + 0.0000 * NOI- 0.0071 * No of tenant.
Interpretation:
The R-Squared statistic indicates that the model as fitted explains 73% of the variability in
Capitalization Rate. The adjusted R-squared statistic, which is more suitable for comparing
models with different numbers of independent variables, is 52% and is also significant. The
standard error of the estimate shows the standard deviation of the residuals to be 0.0064.
Also, ANOVA shows that F value is greater than F critical value and the null hypothesis is
rejected. Thus, there is significant relationship between Capitalization rate and other factors.
Since the P-value in the ANOVA table is less than 0.05, there is a statistically significant
relationship between the variables at the 95.0% confidence level. From the regression line
plot it can be seen that 95% of the predicted values fall in a narrow band. From this we can
say that the regression line is a good fit. Hence the estimating regression equation can be
used to predict the Capitalization Rate.
4.5 MOVEMENT OF CAPITALIZATION RATE WITH REGARD TO PROPERTY
TYPES
Retail:
The following table shows the movement of capitalization rate for the retail property.
Office:
The following table shows the movement of capitalization rate for the office property.
Multi-Family:
The following table shows the movement of capitalization rate for the Multi-family property.
Appraisal US
S. No Cap rate Date Treasury
1 8.35% 8/1/2010 2.38%
2 6.00% 10/1/2010 2.22%
3 7.75% 10/10/2010 2.33%
4 5.25% 11/15/2010 2.18%
Industrial:
The following table shows the movement of capitalization rate for the industrial property.
Appraisal US
S. No Cap rate Date Treasury
1 8.00% 5/3/2010 2.49%
2 6.50% 1/5/2011 2.33%
3 6.75% 9/15/2010 2.32%
Mixed Use:
The following table shows the movement of capitalization rate for the mixed use property.
Appraisal US
S. No Cap rate Date Treasury
1 6.50% 9/1/2010 2.20%
2 8.00% 12/19/2010 2.29%
3 8.00% 1/1/2011 2.33%
Self Storage:
The following table shows the movement of capitalization rate for the self-storage property.
Appraisal US
S. No Cap rate Date Treasury
1 7.75% 11/3/2010 2.29%
2 8.00% 11/13/2010 2.18%
Hotel:
The following table shows the movement of capitalization rate for the hotel property
Appraisal US
S. No Cap rate Date Treasury
1 8.00% 9/19/2010 2.28%
2 9.28% 11/9/2010 2.18%
CHAPTER 5
5.1 FINDINGS
By analyzing the various factors affecting the capitalization rate the following were observed:
• It is observed from the 4 quarter moving average that for the past 10 years the
capitalization rates for the properties are showing a downward trend. This means the
value of the properties is continuously increasing.
• Property type, Location and Market is identified as the best indicator while
considering the factors which affect the capitalization rate.
• It is observed that, higher the quality of the property, lower the capitalization rate and
higher the quality of the tenants, lower the capitalization rate.
• As is value and Age of the property have inverse relationship with the capitalization
rate.
• It is assessed that higher the demand for the specific types of property, the lower the
Capitalization rate.
5.2 SUGGESTIONS
• Investors should take into consideration the factors such as Property type, Location
and Market while investing in the Real Estate Market.
• Not only the property type but also the number of tenants in the property should be
considered since single-tenant property is more risky than the property occupied by
multi tenants.
• Investors should take into consideration the per capita income while deciding the
location of the property.
• The investors should consider the lease term while investing in properties as very low
lease term leads to roll over risk and higher cost of tenant improvements.
• The investor must consider the property type as some properties such as hotels are
more risky due to unpredictable occupancy rate.
• The investors can use the regression model developed in this study to estimate the
capitalization rate of the property.
CHAPTER 6
CONCLUSION
A capitalization rate is simply a ratio of a property’s net operating income (NOI) to its
market value, much like the inverse of a price earnings ratio in the stock market. Both space
and capital market forces affect cap rates. Space market forces influence cap rates directly
through income, while capital market forces affect pricing.
The results from this study indicate that differences across property types are
important in evaluating capitalization rates. The capitalization rates are strongly related to
capital market returns. Factors that seem important today may become outdated and
irrelevant after few years. This is a dynamic, competitive, and highly complex industry. The
framework of factors presented in the text will indubitably help the investors to achieve their
set objectives, gain a competitive advantage, and maximize the return on the real estate
property. Real estate capitalization rates have plunged amid fierce competition for core assets
with secure and predictable cash flows. The real estate industry is capital intensive and relies
heavily on debt.
APPENDIX
Property Classification
Classification of Property type - Based on risk in that property
REFERENCES
Books Referred:
Websites:
• www.zenta.com
• www.cbre.com
• www.pulawski.com
• www.realestatejournal.com
• www.realtyrates.com
• www.articlesbase.com
• www.census.gov
• www.reis.com
• www.ncreif.com
• www.bloomberg.com