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What is the equity capitalization rate?
The equity capitalization rate (ECR) is the capitalization rate that shows the relation between the income from the property in comparison to the equity of the investor. ECR is an important metric as it measures the real cash return at the time of acquisition, i.e., the investor’s money.
Usually, the investor’s own funds contribute towards the acquisition cost of the property. If no there is no loan in financing the acquisition of the property, then the investor’s equity is the net acquisition cost. Otherwise, the investor’s equity is the property acquisition cost from which the loan amount is deducted.
The formula for ECR is −
$$\mathrm{ECR =\frac{Before\:Tax\:Cash \:Flow}{Investor\:Equity}}$$
Where,
Before Tax Cash Flow = Net Operating Income – Debt Service
Investor Equity = Net Acquisition Price – Total Loan Amount
The market-related equity capitalization rate is used to convert property income into an equity market given by the following formula −
$$\mathrm{Investory\:Equity\:Value =\frac{Before \:Tax\:Cash\:Flow}{Equity\:Capitaliztion\:Rate}}$$
The Equity Capitalization Rate (ECR) also shows an estimation of market capitalization rates using the band-of-investment technique and represents the return on equity (ROE) demanded by the investor.
Debt
Usually, most people acquire property with some type of loan. This debt needs to be considered while determining equity capitalization. This, in turn, provides an accurate picture of the real rate of return. To correctly project the ECR, one also needs to subtract the debt and any other additional annual expenses from the company’s net operating income.
Property Expenses
Apart from knowing the debt, one also needs to know the expenses related to managing and maintaining the property. If there is no such record, it will be tough to find these values. As the information of these expenses are mostly not readily available, seeking a broker with related experience and who has an idea of property valuation will be the best bet.
Verification
Verifying both the income and expenses for a property you are interested in is the best way to get the correct picture of the equity capitalization rate. Income is easy to ascertain since the seller will want to show that as a selling point. Expenses are however hard to ascertain, and one may have to press long and hard for the property owner to show it. Knowing the income and expenses would help one to get the real picture of the property and equity capitalization rate.
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