Using the income approach, an appraiser solves the previous formula to determine the value of a property.  To solve for the value, the appraiser needs an appropriate capitalization rate.

The capitalization rate or “cap rate” used by an appraiser is constructed from a mortgage constant and an equity rate of return.  The best way to obtain an accurate cap rate for your locale or type of property is to call an appraiser and ask for it.  You may also ask your banker what cap rates are being used in local appraisals.

You may calculate a cap rate yourself using the following method.  Start by determining typical percentages of equity investment and debt financing for similar investments.  The combined percentage of equity and debt must equal one hundred percent.  For example, you might assume twenty-five percent equity and seventy-five percent debt financing:

Cap Rate = 25% x Equity Rate of Return + 75% x Mortgage Constant

The “equity rate of return” represents an estimate of the required rate of return by investors in similar projects.  The mortgage constant simply represents total annual debt service divided by the loan amount.

Cap rates are usually calculated based upon prevailing market rates of return, interest rates, loan to value ratios, and mortgage amortizations for similar properties.  The specific numbers that appraisers plug into the cap rate formula are often determined by judgment calls.  Because of this, it is important to learn why appraisers use certain values and whether different appraisers in your area might make different assumptions.