Capitalization
Rates
The use of appreciation as a predictor of future value typically
makes sense when the desirability of the subject property is based
on something other than its rental income. For example, consider
a single-user property such as a small retail building on a main
thoroughfare. The owner of a business operating as a tenant
in such a location is probably willing to spend more for the building
than an investor would pay. In general, rate of appreciation
as a predictor of future value may be appropriate when comparable
sales work well as a measure of present value (i.e., "Commercial
buildings on Main Street are selling for $200 per square foot by
next year they will be up to $225."). However we as investors
must use something called a Cap Rate.
CAPITALIZATION
With most other types of income-producing real estate, what you
paid for the property is not likely to make much of an impression
on a new buyer. Witness the rapid run-up and even faster collapse
of prices in the late ‘80s. The typical investor will be interested
in the income that the property can generate now and into the future.
He or she is not buying a building so much as an income stream.
That investor is most likely to use capitalization of income as
the method of estimating value. You have probably heard this referred
to as a "Cap Rate" method. It assumes that an investment
property’s value bears a direct relation to the property’s
ability to throw off net income.
Mathematically, a property’s simple capitalization rate is
the ratio between its net operating income (NOI) and its present
value:
Cap. Rate = NOI/Present Value
Net
operating income is the gross scheduled income less vacancy
and credit loss and less operating expenses. Mortgage payments and
depreciation are not considered operating expenses, so the NOI is
essentially the net income that you might realize if you bought
the property for all cash. If you purchase a property for $100,000
and have a NOI of $10,000, then your simple capitalization rate
is 10%.
To use capitalization to predict value requires just a transposition
of the formula:
Present Value = NOI/Cap. Rate
The projected value in any given year (i.e., the "present
value" in that year) is equal to the expected NOI divided by
the investor's required capitalization rate.
To use capitalization rate as a predictor of future value,
in short, is to use this logic: "I am buying this
property with the expectation that its net operating income will
represent a return on my investment. It is reasonable to assume
that whoever buys the property from me in the future will have a
similar expectation. That new investor will probably be willing
to purchase the property at a price that allows it to yield his
or her desired rate of return (i.e., capitalization rate)."
EXAMPLE 1 A rental property will yield a NOI of $27,000, and the
new buyer will require a 9% rate of return (capitalization rate),
then you will estimate a resale price of $300,000.
EXAMPLE 2 The same property above is listed for 400,000 with the
same NOI of 27,000 what is the Rate of return(CAP Rate)?
27,000 / 400,000 = 6.7% return
EXAMPLE 3 The same property boosted its NOI to 35,000 and the new
buyer wants a 11% return on his investment what could he afford
to pay?
35,000(NOI) / .11 (CAP) = $318,181
The same is true of your estimate of a new buyer’s required
cap rate. Look at the investment from the new buyer’s point
of view and remember that there are other opportunities competing
for his dollar. Would you buy an office building with a projected
cap rate of 9% if you could buy a bond that yields 8%? What if mutual
funds are rocking and rolling at 15% and more? To attract a buyer,
your property may need to be priced so that its cap rate is competitive.
The higher the cap rate, the lower the price. In our example above,
the property with the $27,000 NOI capitalized at 15% would be worth
only $180,000. |
