Posted by Ed Garcia on March 08, 2000 at 10:08:42:

Explaining a Cap Rate:

GLD:

You take your NOI which stands for (Net Operating Income).

Divide it by the Cap Rate you desire.

This helps you decide the value of the property based on the income.

Example:

You have a property that nets you $2500. a month after expenses.

You then multiply $2500. times 12 months = $30,000.

Lets say you want a 8 cap rate.

You then take $30,000. divide it by .08 = 375,000.

At an 8 cap the value of your property is $375,000.

GLD, now here is a more detailed explanation.

Why do you in invest in income-producing real estate? Perhaps you are

looking cash flow. Possibly you anticipate some tax benefits. Almost

certainly, you expect to realize a capital gain, selling the property

at some future time for a profit.

Your projection of the future worth of the property, therefore, can be

a vital element in your investment decision.

INFLATION

A fairly simple approach to this issue is the use of an inflation

rate. You bought the property today for X dollars. You make a

conservative estimate as to the rate of inflation, apply that rate to

your original cost and improvements and come up with presumed future

value.

The use of inflation 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 inflation 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.").

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’s. 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 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)."

If you project that the property will yield a NOI of $27,000, and that

a new buyer will require a 9% rate of return (capitalization rate),

then you will estimate a resale price of $300,000.

You must never forget that, while the algebra involved here is simple,

the judgments you need to make in order to achieve an accurate

prediction of value are more complex. Your assumptions as to future

years’ income and expenses have to be realistic.

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 12% would be worth only $225,000.

Our discussion here has been limited to simple capitalization rates.

If you would like to delve deeper into this topic (for example,

mortgage-equity cap rates), an appraiser’s text on income-property

valuation should be your next step.

For more information, go to http://www.realdata-inc.com

Copyright 1996, RealData ©, Inc.

Reprinted with permission of the author.

Ed Garcia