Joseph H. Martin, MAI, and Mark W.

Sussman, MAI

The Twelve Rs: An

Overview of Capitalization
Rate Derivation

The development and proof of the overall rate (RO) in direct capitalization is as
important today as it was 10 or 20 years ago. The difference is that today there
are 12 ways to prove or disprove an overall capitalization rate, and with which
even parts of the overall rate can be proven. One way this is accomplished is by
using available formulas to solve for components that can alternatively be used
to derive the overall rate, and then comparing those components against mar-
ket expectations to test their validity. This article explains the 12 ways an over-
all rate can be developed and tested in the real world.

I n current Appraisal Institute courses, stu-

dents are learning ways to create and prove
an overall rate, a rate necessary to convert one
year of income into value, by a process known
as direct capitalization. All too often apprais-
ers get comfortable with only one way to cre-
ate or prove a capitalization rate in their ap-
praisal practice without knowing, checking,
or proving their rate with other methods.
Some argue that direct capitalization is a thing
of the past, and that creating or attempting to
convert a single year’s income into value is a
useless academic exercise in today’s world of
computers and data available for conversion
of income into value by sophisticated dis-
counted cash flow (DCF) analyses. Even with
computers and yield analyses, an appraiser
must be able to prove his or her rate of conver-
sion, whether it is a capitalization rate or a yield
rate, and should know the many ways to prove
or disprove a rate selection. Further, there are
many commercial properties that should be
valued by direct capitalization. DCF analysis
may be the only way to value investment-
grade real estate, but for the bulk of smaller,
noninvestment-grade real estate, direct capi-
talization simulates the process used by buy-
ers and sellers in those types of markets.
The authors have determined that there
are 12 different ways to derive and prove an
overall rate for direct capitalization.1 They
are as follows:

1. Most of the formulas discussed here are presented in Appraisal Institute courses “Basic Income Capitalization” (310) and “Ad-
vanced Income Capitalization” (510).

Joseph H. Martin, MAI, is president of Martin Appraisal Associates, Inc., Lawrenceville, New Jersey. He
received his BS in business administration at Rider College, Lawrenceville, and is an instructor for the Ap-
praisal Institute. He is an author of several textbooks on real estate licensing.
Mark W. Sussman, MAI, is vice president of John O. Lasser Associates, Inc., Livingston, New Jersey. He
provides appraisal and consulting services on a wide variety of property types, with emphasis on ad
valorem tax litigation and condemnation. He received his BA in psychology from Lehigh University,
Bethlehem, Pennsylvania, and is an instructor for the Appraisal Institute.

149
 IO by a rate, or by multiplying income by a fac-
RO = tor. In the second scenario, multiplying in-
VO (1)
come by a factor, the income can be poten-
This is the universal formula of rate de-
tial gross income (PGI) or effective gross in-
velopment. It is generally market extracted
come (EGI). This approach is generally used
when the appraiser knows the net operating
in the sales comparison approach to value
income (IO) and the value or price (VO) of a
and is not considered a capitalization ap-
property. The RO derived by this formula
proach per se. However, two simplistic parts
implicitly contains all of the assumptions
of this formula can be quickly extracted from
about investor expectations inherent in that
the market, i.e., the gross income multiplier
particular sale or value, and to be useful
(GIM) and the net income ratio (NIR), which
should be applied to only those properties
is the complement of the expense ratio. As
that have the same characteristics as the sale
an example, simple research would indicate
(i.e., same land and building ratios, use, lease
what the gross rental would be from the
terms, vacancy rates, expense ratios, value
market at the time a property is sold, and a
or income expectations, level of risk and in-
gross income multiplier could be developed
vestor motivation). It would be inappropri-
by dividing the sales price by the potential
ate to extract an overall rate from a sale of an
gross income (SP ÷ PGI = PGIM). Further
80-unit, older, urban, mid-rise apartment
analysis of the comparable sales would in-
complex and use it directly to value a newer,
dicate the typical expense ratio, and 100%
150-unit, suburban garden complex. Expense
less the expense ratio would equal the net
ratios, appreciation in value, risk, and inves-
income ratio. Once these two figures are
tor motivation between these two properties
known, a potential overall rate can be devel-
would be too great to make a direct compari-
oped by simply applying the formula ex-
son. However, once the overall rate (RO) is
pressed above.3
extracted, it can be useful for comparable
properties, and since it is market extracted,
RO = DCR × M × RM (4)
it is very persuasive.
Commonly referred to as the
RO = SR + LR + MR + RR (2) “underwriter’s method” of developing an
overall rate and used by lenders with their
This old formula of developing a built-
own requirements for debt coverage ratio
up overall rate is antiquated. Here, an over-
(DCR), mortgage or loan-to-value ratio (M),
all rate is built up through a combination of
and mortgage constant (RM), it is a good tool
a safe rate (SR), a liquidity rate (LR), a man-
when it is market derived. All appraisers
agement rate (MR), and a risk rate (RR). To
should check with their mortgage sources
assume that an appraiser would have the
on the type of property they are appraising
judgment to assign a proper factor for loss
and know these components of lender re-
of liquidity, or management, or risk in
quirements. It is based on the premise that
today’s complex and changing economic cli-
the lender establishes the control on vari-
mate, and to develop a rate in this fashion
ous properties by controlling the amount of
are incomprehensible. It can, however, be
risk they will take (loan-to-value ratio or M),
useful in making comparative judgments
the interest rate and term they require (the
once an overall rate has been created through
mortgage constant or RM), and the amount
other means.2
of net operating income they deem safe to
cover the debt (debt coverage ratio or DCR).
NIR
RO = The loan-to-value ratio and mortgage con-
GIM (3) stant are used in both the band of invest-
There are only two ways direct capitali- ment and the Ellwood formula for devel-
zation can be employed: by dividing income oping overall rates, and debt coverage ra-

2. Charles B. Akerson, “Builtup and Blended Rates,” Capitalization Theory and Techniques Study Guide (Chicago: American Institute of
Real Estate Appraisers, 1984), 21. It should be acknowledged that these builtup rates are truly yield rates and, therefore, even if an
appraiser has the judgment or expertise to develop an overall rate by this method, he or she would have to convert the yield rate
to an overall capitalization rate.
3. Ibid., 18. The problem in this approach to prove an overall rate is that it may not be possible to determine the true expenses in a sale
property, unless the appraiser is involved in the transaction or has direct knowledge of this information. Relying on third-party
information for the actual expenses at the time of sale may be insufficient to develop an accurate overall rate. However, if the
appraiser is cautious and uses typical expressed expense ratios, it still becomes a good check on other methods developed here.

150 The Appraisal Journal, April 1997

tios are easily surveyed or acquired from
mortgage research sources such as the
American Council of Life Insurance Com-
panies’ Investment Bulletin.4
If the assumptions of loan-to-value ratio
(M), mortgage constant (RM), and debt cover-
age ratio (DCR) come from a specific lender
rather than comparable market data, the over-
all rate will reflect the lender’s value rather
than market value. Appraisers who use the
Ellwood or band of investment method to
develop an overall rate (RO) would do well to
check this rate by using the formula:
RO
DCR =
M × RM
If the debt coverage ratio (DCR) calcu-
lated using this formula is inconsistent with
current bank lending criteria applicable to
the subject property, then the overall rate de-
rived through the Ellwood or band of invest-
ment method may be flawed.5
RO = M × RM + (1 − M)RE
Known as the band of investment
method of developing an overall rate, this is
based on the presumption that a capitaliza-
tion rate should amount to a weighted aver-
age of debt and equity funds, dependent on
the risk quality of the property investment.
Also known as the mortgage equity analy-
sis, the formula simply states that the over-
all rate (RO) is the weighted average of the
mortgage capitalization rate (the mortgage
constant or RM), and the equity capitalization
rate (RE). The overall rate generated by this
formula must satisfy both the mortgage re-
quirement of the lender and the pre-tax cash
flow requirement of the equity participant.
Since it is a composite rate, weighted in pro-
portion to the investment represented by
debt and equity, it is believed by some to be
infallible because the greatest weight toward
the overall rate is the debt requirement which
can be easily obtained by a survey of lend-
ers in the type of investment property to be
valued. It is a popular method used by ap-
praisers to develop an overall rate, but is of-
ten misused because the data used to de-
velop the rate is from surveys of lenders and
4. American Council of Life Insurance Companies, Investment Bulletin (Washington, D.C.: American Council of Life Insurance Com-
panies).
5. The Appraisal of Real Estate, 10th ed. (Chicago: Appraisal Institute, 1992): 472–473.
6. Ibid., 470–471.
7. Ibid., 472.
Martin/Sussman: The Twelve Rs: An Overview of Capitalization Rate Derivation
equity participants, not from hard market
data. It is a good way, however, to test a capi-
talization rate developed from better market-
oriented sources.6
RO = L × RL + B × RB (6)
Another band of investment technique
is derived using the relationship of known
physical components of property, i.e., the
land and the buildings. The ratio of land
value and/or building value to the overall
property value must be known, as well as
the capitalization rate for each physical com-
ponent. Used primarily in land and/or
building residual techniques where one
value is known, the income for that value can
be extracted from the net operating income
by multiplying the appropriate capitalization
rate by the known value. The residual in-
come is then capitalized into a value estimate
by its appropriate rate.
It is a good technique in highest and best
use analysis where building values are
(5)
known or can be reasonably estimated and
the question is what is the most profitable
use of the land.7
RO = YO (7)
When an appraiser expects that income
and value will remain unchanged during a
holding period, the property is basically val-
ued by capitalization in perpetuity, i.e., the
overall capitalization rate and the yield rate
are synonymous. In other words, the yield
to the property investment is equal to the rate
of return.
RO = YO − ∆O a (8)
When there is a change in income and/or
value over a holding period, the above for-
mula can be adjusted accordingly. This is a
general purpose formula to develop an over-
all capitalization rate where RO is the cap rate,
YO is the property yield rate, ∆O is the change
in property value and a is the appropriate
conversion factor. At present, there are three
variations of the conversion factor based on
the appraiser ’s perception of anticipated
changes in income and value over a projected
151
 holding period, each of which will change
the overall rate (RO).8
RO = YO − ∆O 1 ⁄Sn
If it is forecasted that income will remain
level and value will change over the projected
holding period, the overall change in value
(∆O) is multiplied by the sinking fund factor
or SFF (calculated based on the yield rate and
the holding period) to derive an appropriate
capitalization rate. Typically, it would be un-
usual for net income to remain completely
level over a holding period and still have an
expected change in value. However, this may
be appropriate in those situations where a
property is under a long-term net lease at a
flat rent, and property values are increasing
or decreasing due to supply and demand fac-
tors or are in an inflationary market.
RO = YO − ∆O 1 ⁄n
Where it is assumed that both income
and value change on a straight-line basis
during a holding period, the overall change
in value (∆O) is multiplied by the inverse of
the number of years in the projected hold-
ing period (1⁄n).
RO = YO − CR
If both income and value are expected
to change at a constant ratio (compound rate)
over a holding period, then the overall rate
(RO) is simply the expected yield rate (YO)
adjusted by the rate of change (CR). It stands
to reason that if the investor’s expected yield
rate is 12%, and both income and value
change at +2% per year, then the overall capi-
talization rate is 10%, or 12% less 2%.9
YE − M(YE + P 1⁄Sn − RM) − ∆O 1⁄Sn
RO =
(1 + ∆I J) or (K)
Most readers will recognize this as the
Ellwood formula which derives an overall
capitalization rate that incorporates equity
yield requirements and mortgage financing
terms. Developed by L. W. Ellwood and re-
defined by Charles B. Akerson, it is the alge-
braic equivalent of DCF analysis.10
The Akerson format expressed algebra-
(9) ically is as follows:
RO = (M × RM) + (1 − M) YE − M × P 1⁄Sn − ∆O 1⁄Sn
The Akerson format as it is more com-
monly used is shown below. When presented
in this manner, it is easier for most people to
comprehend and to solve step by step than
the algebraic formula.
Mortgage ratio (M) × Mortgage constant (RM) = 0.000000
+ Equity ratio (1 − M) × Equity yield rate (YE) = 0.000000
Weighted average
Adjustment for Equity Buildup:
− Mortgage ratio (M) × Part paid off (P)
× Sinking fund factor (1 ⁄Sn) = 0.000000
Basic rate (r)
Adjustment for Appreciation/Depreciation:
(10) − (+ ∆O) × Sinking fund factor (1⁄Sn) = 0.000000
Overall rate (RO )
The first part of Akerson’s format closely
resembles the simple band of investment
method with one important difference: The
equity rate used here is the equity yield rate
(YE), not the equity capitalization rate (eq-
(11) uity dividend rate or RE) found in the band
of investment. The next line adjusts the mort-
gage/equity-weighted average for the equity
buildup that accrues to the investor as the
mortgage is paid off, and this adjusted rate
is known as the basic rate (r). The last line
adjusts the basic rate for total anticipated
appreciation or depreciation over the hold-
ing period to arrive at the overall capitaliza-
tion rate (RO).
Originally the Ellwood formula was de-
veloped only for level income streams, and
was later refined to allow for variations when
(12) different income patterns were anticipated,
by the use of the Ellwood J-factor or the K-
factor. However, with the use of today’s fi-
nancial calculators and personal computers,
a simpler method, no matter what pattern
of income is expected over a holding period,
is to find the equivalent level income.11

8. Ibid., 494–495.
9. Ibid., 498. It is unrealistic in the real world to expect both income and value to change at the same rate during an anticipated
holding period. The only exception to this may be in a leased fee analysis where the lease is written to guarantee both a constant
increase in income and a resale price at the same rate of growth.
10. Some argue that the Ellwood technique is obsolete with the widespread availability of easy-to-use spreadsheet programs that
can perform complex DCF analyses quickly, accurately, and inexpensively. See Wayne Kelly, Donald R. Epley, and Phillip
Mitchell, “A Requiem for Ellwood,” The Appraisal Journal (July 1995): 284–290.
11. An excellent reference on how to calculate equivalent level income can be found in Course 510, Session 6: “Stabilizing Income
and Yield Capitalization (DCF) Using an Equity Yield Rate.”

152 The Appraisal Journal, April 1997

 Knowing the 12 Rs provides the appraiser
with a complete bag of tools with which to
test, develop, reason, and prove value. As an
example, assume an appraiser is valuing a
property with a net operating level income of
$300,000. This income should remain stable
for the foreseeable future. This appraiser’s
standard operating procedure is to use only
the band of investment method to develop an
overall capitalization rate (RO). A survey of
local lenders indicates that they would lend
money based on a loan-to-value ratio of 70%,
at a fixed interest rate of 10% with monthly
payments for a term of 20 years. Further, a
survey of investors indicates that they expect
a 12% cash-on-cash return (RE). The overall
capitalization rate would be derived through
the band of investment method as follows:
RO = M × RM + (1 − M) RE
= 0.70 × 0.1158 + 0.30 × 0.12
= 0.08106 + 0.03600
= 0.11706
The overall value (VO) would then be:
$300,000 ÷ 0.11706 = $2,562,788
(rounded) $2,560,000
Further investigation would have also
disclosed that lenders typically expect a DCR
of 1.35, that investor’s holding periods are
generally not more than 10 years, and that
the yield expectation for investors is 14%.
A check on the band of investment rate
selection could be made by (a) the
underwriter’s method, and (b) the Ellwood
formula, as follows:
RO = DCR × M × RM (a)
= 1.35 × 0.70 × 0.1158
= 0.10943
VO = $300,000 ÷ 0.10943
= $2,741,478
(rounded) $2,740,000
YE − M(YE + P 1⁄Sn − RM) − ∆o 1⁄Sn
RO =
(1 + ∆I J) or (K) (b)
= 0.14 − 0.70 (0.14 + (0.26976 × 0.05171)
− 0.1158) − (−0.10 × 0.05171)
= 0.14 − 0.70 (0.03815) + 0.005171
= 0.14 − 0.02671 + 0.005171
= 0.11846
Martin/Sussman: The Twelve Rs: An Overview of Capitalization Rate Derivation
VO = $300,000 ÷ 0.11846 = $2,532,500
(rounded) $2,530,000
The value estimates obtained by deriv-
ing the overall capitalization rate (R O)
through two different methods range from
$2,530,000 to $2,740,000. This reflects a dif-
ference of 8.3% or $210,000—a significant di-
vergence although both methods are based
on the same set of facts. The question begs
itself: Which is the correct way to develop
an overall rate, and which value estimate is
right? The answer lies in the type of prop-
erty being valued and the most likely way
an investor in the market for the subject prop-
erty develops or creates his or her capitali-
zation rate.
As another example, assume a similar set
of facts. The subject property is expected to
continue to produce a level net operating in-
come of $300,000. A market investigation in-
dicates that local lenders will lend money
based on a loan-to-value ratio of 70%, at a
fixed interest rate of 10% with monthly pay-
ments for a term of 20 years, and an expected
debt coverage ratio (DCR) of 1.25. Investor’s
holding periods are generally not more than
10 years, and investors’ yield expectations
are 14%. The market for this class of prop-
erty is expected to appreciate approximately
50% over a 10-year holding period, or 4.14%
per year compounded. (This was not an un-
usual assumption during periods of rapid
inflation such as the mid-1980s, when some
markets experienced increases of 15%–20%
per year.) A market survey indicates that in-
vestors are willing to accept a cash-on-cash
return (RE) of 6% probably due to the antici-
pation of significant appreciation in property
value.
The appraiser in our example consis-
tently uses the Ellwood mortgage-equity
analysis presented in the Akerson format.
After all, this advanced technique accounts
for every component of value in the overall
capitalization rate, including the investors’
required equity yield (YE), mortgage financ-
ing, the equity buildup (P) accrued by mak-
ing mortgage payments over the holding
period, thereby reducing the principal bal-
ance, and the effects of any appreciation or
depreciation in property value (∆O). The
overall capitalization rate (RO) is derived as
follows:
153
 Weighted Average:
70.0% Mortgage × 0.1158 Mortgage constant = 0.08106
30.0% Equity × 0.1400 Equity yield rate = 0.04200
Weighted average: 0.12306
Less Equity Buildup:
70.0% Mortgage × 0.26976 Part paid off
× 0.05171 Sinking fund factor = 0.00976
Basic rate: 0.11330
− Appreciation/+ Depreciation:
50.0% Appr. × 0.05171 Sinking fund factor = −0.02586
Overall capitalization rate 0.08744
(rounded) 8.74%
Capitalizing the net operating income of
$300,000 at the indicated overall rate of 8.74%
results in a value estimate of $3,432,500. The
appraiser, after checking his calculations
twice concludes a value of $3,432,500.
Once more, the formulas presented here
can be used to check the validity of the de-
rived overall capitalization rate of 8.74%, in-
cluding (c) the underwriter’s method, and
(d) the band of investment technique:
RO = DCR × M × RM (c)
and
RO
DCR =
M × RM
0.0874
=
0.70 × 0.1158
= 1.08
Clearly, this analysis shows a debt cov-
erage ratio significantly lower than the 1.25
DCR required by lenders as found in the
appraiser’s market investigation. Something
is wrong and should be a red flag to the ap-
praiser that further investigation and a re-
view of the assumptions on which the over-
all rate is based may be needed.
RO = M × RM + (1 − M)RE (d)
and
appraiser to review the assumptions on
which the overall rate is based.
If the appraiser uses these techniques as
a check, the inconsistencies will become
readily apparent. He or she reviews the as-
sumptions and finds that the anticipated ap-
preciation of 50% over the 10-year holding
period is overly aggressive, and tempers the
expected increase in property value to 25%.
The resulting Ellwood/Akerson capitaliza-
tion rate derivation now appears as follows:
Weighted Average:
70% Mortgage × 0.1158 Mortgage constant = 0.08106
30% Equity × 0.1400 Equity yield rate = 0.04200
Weighted average: 0.12306
Less Equity Buildup:
70.0% Mortgage × 0.26971 Part paid off
× 0.05171 Sinking fund factor = 0.00976
Basic rate: 0.11330
− Appreciation/+ Depreciation:
25.00% Appr. × 0.05171 Sinking fund factor = −0.01293
Overall capitalization rate 0.10037
(rounded) 10.04%
The appraiser again applies the same for-
mulas to check the consistency of his as-
sumptions and finds the following:
RO = DCR × M × RM (e)
and
RO
DCR =
M × RM
0.1004
=
0.70 × 0.1158
= 1.24
The indicated debt coverage ratio is now
consistent with the DCR required by local
lenders as found in the appraiser’s market
investigation.
RO = M × RM + (1 − M)RE (f)

RO − (M × RM) and
RE = RO − (M × RM)
1−M
RE =
0.0874 − (0.70 × 0.1158) 1−M
= 0.1004− (0.70 × 0.1158)
1 − 0.70
=
= 0.02113 or 2.11% 1 − 0.70
= 0.06447 or 6.45%
Similarly, this analysis indicates a cash-
on-cash return (equity dividend rate, RE) of Again, using the formula as a check in-
2%, far below the 6% return required by dicates a cash-on-cash return (equity divi-
market participants. Again, there is an incon- dend rate, RE) that is consistent with the 6%
sistency and this type of check can warn an return required by market participants.

154 The Appraisal Journal, April 1997

 This process of testing capitalization
rates resulted in revising the overall capitali-
zation rate from 8.74% to 10.04%. Based on a
first-year net operating income of $300,000,
the estimated value is reduced from
$3,432,000 to $2,988,000. This reflects a de-
crease of 13%, which is significant in any
appraisal assignment.
As has been shown in this article, it is
imperative in today’s real estate investment
world to look at all the ways an overall capi-
talization rate can be developed and to use
all the data available in the market to develop
and test overall rates for every income valu-
ation problem.

Martin/Sussman: The Twelve Rs: An Overview of Capitalization Rate Derivation 155