What Is The Income Capitalization Approach?
Net Operating Income (I) / Capitalization Rate (R) = Property Market Value Cap Rate Calculation
While the cap rate is important for analyzing
and comparing real estate investment opportunities, it’s only one of many
metrics to find the rate of return. So, property investors should use the cap rate
calculation together with others (like the gross rent multiplier and cash on cash return) to ensure making the right investment
decisions. To learn more about these, keep reading our real estate investment blog – it’ll teach you everything you need to start your real
estate investing career
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When
it comes to determining the value of real estate, there's no perfect
method. But from an investor point of view, the income a property produces is a
great starting point for determining how much a property is worth. The income
capitalization approach is a method of real estate valuation that uses a
property's annual income to determine its fair market value.
In
this article, we'll take a closer look at how the income capitalization
approach works, how to use it, and some drawbacks to the approach investors
should know about, as well as some alternative (or complementary) valuation
approaches real estate investors may want to
consider.
What is the income capitalization approach?
The
income capitalization approach to property valuation, also commonly referred to
as the income approach, is a method by which real estate investors attempt to
determine the fair market value of real estate based on the amount of net
operating income (N.O.I.) the property generates.
While most commonly used when evaluating commercial investment properties, it
can theoretically be applied to any type of income property.
Specifically,
the income capitalization approach uses two variables to determine a property's
market value. First is the net operating income, or NOI, which refers to a
property's income after all its operating expenses are paid. Second is
the capitalization rate, or capitalization rate,
a percentage that expresses a property's estimated NOI as a percentage of its
market value.
How to estimate N.O.I.
Experienced
real estate investors likely know how to calculate N.O.I. But if you're new
to commercial real estate investing, NOI is
equal to a property's gross income (typically its rental revenue) minus the
property's operating expenses. In other words, an investment property that
generates Rs.50,000 in annual rental income and has Rs.15,000 in operating expenses
would have Net income of Rs.35,000.
Operating
expenses include items like maintenance costs, insurance expenses, and services
such as landscaping and cleaning, as well as any repairs you pay for.
Property tax is also considered
an operating expense. It does not include any debt service
(such as your mortgage payments) as an
expected cash flow calculation would, and it also doesn't include any capital
expenses you incurred.
Calculating valuation using the income
capitalization approach
Once you've calculated a
property's NOI and determined its cap rate, you can estimate its value by
dividing the two numbers.
Here's a simplified
example: Let's say you're in the market for an office property and find one
generating rental revenue of $100,000 per year. You estimate the property's
operating expenses will be about $25,000 per year, so you can reasonably expect
the subject property to produce net operating income of $75,000 in your first
year of ownership.
Based on a recent cap
rate survey, you determine the market average cap rate for this type of
property in your local market is 6.5%. By dividing the $75,000 in estimated NOI
by this cap rate (remember to convert the percentage to a decimal, or 0.065),
the property's fair market value by the income capitalization approach would be
just over $1.15 million. This can help you determine how much to offer for a
property on the market or decide how much to ask for a property you plan on
selling.
Shortcomings of the income capitalization
approach
There's no perfect way to
determine the value of real estate. If I were to ask five experienced real
estate investors to calculate the value of an office building, they'd probably
use five different valuation methods -- and come up with five different
numbers.
Even within the same
valuation method, there can be significant variances. So when using the income
capitalization approach, here are shortcomings you should be aware of:
·
Even
if a property is currently leased to tenants, it's difficult to calculate NOI
with accuracy. Several operating expenses can be particularly hard to predict,
such as maintenance costs and marketing expenses, just to name a couple.
·
Determining
what cap rate to use isn't an exact science. You can use market-average cap
rates from an industry report, but that doesn't take into account some
particular variables of a specific property. Alternatively, you could ask an
experienced commercial real estate broker for their opinion, or you can do your
own market analysis based on comparable
sales to determine the property's cap rate.
·
Property-specific
factors can dramatically affect the property's market value. For example, if a
building immediately needs a new roof, it would be worth less than a comparable
property with a roof in excellent shape. Different lot sizes can also play a
big role. Two apartment buildings might produce the exact same NOI, but if one
is on twice as much land, it plays a role in valuation. After calculating a
property's value with the income approach, it can be a good idea to make
adjustments for any factors like these.
Other methods of determining property values
As I alluded to in the
last section, there are many different ways an investor can determine the value
of a commercial property. Aside from the income capitalization approach --
which is certainly one of the most popular and effective -- there are two other
popular methods:
·
Sales comparison approach: This method
involves examining sales of similar properties, also known as comparable
properties or sales comps, in the same geographic
region to determine fair market value of a property. This can be a better way
to find a location-specific property value, especially if you're in a
particularly active real estate market where conditions are changing rapidly.
·
Cost approach: The cost approach
to real estate valuation is essentially a sum-of-the-parts analysis of the
property. In a nutshell, it involves determining how much it would cost to
build a similar property from the ground up and then make adjustments for its
current condition.
Is the income capitalization approach the
best way to go?
As
with any valuation model, the best way for real estate investors to use the
income capitalization model is in combination with several other valuation methods.
As mentioned, all valuation methods have shortcomings, so
incorporating a few of them into your investment activities can give you a
better idea of how much a particular property is truly worth.
A final thought: The
income capitalization approach is only as effective as your assumptions when
calculating it, so I strongly suggest you err on the side of caution when
estimating a property's NOI as well as in the cap rate you use. (Note: A higher
cap rate produces a lower valuation.) In short, it's better to be conservative
than overvalue a potential investment.
The Income Approach to Real Estate Valuation
The income approach is
one of three techniques commercial real estate appraisers use to value real
estate. Compared to the other two techniques (the sales comparison approach and
the cost approach), the income approach is more complicated and therefore it is
often confusing for many commercial real estate professionals. In this article,
we’ll walk through the income approach to property valuation step by step,
including several income approach examples.
What is the Income
Approach to Valuation?
The income approach is
a methodology used by appraisers that estimates the market value of a property
based on the income of the property. The income approach is an application
of discounted cash flow analysis in finance. With the income approach, a
property’s value today is the present value of the future cash flows the owner
can expect to receive. Since it relies on receiving rental income, this
approach is most common for commercial properties with tenants.
There are two methods
for capitalizing future income into a present value: the direct capitalization
method and the yield capitalization method. The difference is that the direct
capitalization method estimates value using a single year’s income while the
yield capitalization method incorporates income over a multi-year holding
period. Let’s take a look at both methods in some more depth.
Income Approach: The
Direct Capitalization Method
The direct
capitalization method estimates property value using a single year’s income
forecast. The income measure can be Potential Gross Income, Effective Gross
Income, or Net Operating Income. Direct capitalization requires that there is
good, recent sales data from comparable properties. The comparable sales
provide the appropriate market multiplier to use with the subject property. You
can find the average market multiplier after finding reasonable comparable
sales data. The following formulas are three ways to find the market multiplier
using different measures of income:
1.
Potential Gross Income
Multiplier (PGIM) = sales price / PGI
2.
Effective Gross Income
Multiplier (EGIM) = sales price / EGI
3.
Net Income Multiplier
(NIM) = sales price / NOI
After finding the
market multiplier, multiply the subject property’s forecasted income by the
market multiplier. For example, multiplying the market PGIM by the subject
property’s forecasted PGI in the next year yields the current subject value
estimate. Direct capitalization requires that the income and expense ratios are
similar for the comparables and the subject property and that the next year’s
income is representative of future years.
Income Approach: The
Yield Capitalization Method
The yield capitalization
method is a more complex approach to valuation. This method uses net operating
income estimates for a typical investment holding period. Therefore, the
resulting property value accounts for future expected changes in rental rates,
vacancy, and operating expenses. Yield capitalization doesn’t require stable
and unchanging market conditions over the holding period. The yield
capitalization method also includes an estimate of the expected sales price at
the end of the holding period. Let’s take a closer look at how the yield
capitalization method works.
Components of the
Yield Capitalization Method
Using the yield capitalization method, the subject value estimate is the present value of the future expected cash flows. The present value formula simply sums the future cash flows (P) after discounting them back to the present time. Applying this formula, the cash flows are the proforma estimates of net operating income (P1 through Pn), the required rate of return is r, and n is the holding period. Although the formula calculates present value (PV), it should be noted that both Excel and popular financial calculators utilize the net present value (NPV) formula to find the present value of uneven cash flows. This works because you can simply plug in $0 for the initial investment amount, and then the resulting net present value amount will equal the present value.
·
Cash
Flow Forecasts. Forecasting the cash
flows that an income-producing property will generate over the next year is
relatively straightforward and accurate. Properties already have tenants with
leases in place, and costs should not vary dramatically from their current levels.
The more challenging part of cash flow forecasting comes when considering what
happens to cash flows over the next couple of years. In addition, any
forecasting errors in one year tend to compound themselves in the subsequent
years. Holding periods of 5-10 years are the most common, and those estimates
require forecasting future market rent, vacancy and collection loss, and
operating expenses.
·
Resale
Value. Calculations using the
income approach assume that the owner sells the subject property at the end of
the holding period. Appraisers can estimate resale value using a direct dollar
forecast or an average expected annual growth rate in property values. Direct
dollar forecasts are not preferred because they don’t directly account for any
market expectations. Growth rates consider forecasted market growth rates, but
the subject property’s value may grow at a rate that differs from the market
average. A third method applies direct capitalization techniques to the end of
the holding period. For example, an appraiser considering a five-year holding
period would extend the proforma cash flow estimates one additional year. The
expected sales price at the end of the fifth year would equal the NOI in the
sixth year divided by a market capitalization rate.
·
Discount
Rates. In corporate finance,
the discount rate in a net present value calculation is
usually the firm’s weighted average cost of capital. When valuing an
investment, however, the discount rate is usually represented as the required
rate of return. Real estate investors may use the required rate of return on
their investment properties or the expected rate of return on an
equivalent-risk investment.
Income Approach
Example Using Direct Capitalization
One of the benefits of
direct capitalization is that it provides a way to get a quick valuation
estimate. Appraisers can quickly get a market multiplier from recently sold
property transactions. Consider two recently sold comparables, one with PGI of
Rs.300,000 and a sales price of Rs.2.1 million and another with a PGI of Rs.225,000
and a sales price of Rs.1.8 million. The first yields a PGIM of 7
(Rs.2,100,000/Rs.300,000) while the second yields a PGIM of 8
(Rs.1,800,000/Rs.225,000). So, the market average PGIM of 7.5 can be applied to a
subject property’s PGI estimate to provide a quick valuation. If a subject
property’s expected PGI next year is Rs.195,000, multiply that by the market PGIM
to estimate the subject value.
Subject Value =
Rs. 195,000 x 7.5 = Rs.1,462,500
Appraisers also use
direct capitalization together with residual valuation techniques to find the
value of a property when only the value of the land or the value of the
improvements is known. The value of the land may be known from a separate analysis
using comparable land sales data. From this analysis, suppose the land value is
$350,000 with a 9% land capitalization rate. Further, suppose the improvements
alone have a 10% capitalization rate.
The portion of the
property’s NOI that is generated by the land can be calculated by multiplying
the land value and land capitalization rate. The remaining income is attributed
to the improvements.
Dividing the return
contribution of the improvements by the improvements capitalization rate
results in a valuation of Rs. 2,185,000 for just the improvements. Adding the land
value to the value of the improvements results in a total property value
estimate of Rs. 2,535,000.
Income Approach
Example Using Yield Capitalization
In order to estimate
the subject property value using the income approach, the first step is to
create a proforma cash flow statement for the anticipated holding period. Using
the following market assumptions, let’s estimate the cash flows to the owner
over a five-year holding period.
·
The subject property
is expected to yield PGI of Rs.200,000 over the next year and currently has a 5%
vacancy rate. Operating expenses are currently 45% of EGI, and that is expected
to stay the same during the holding period.
·
Market rent is
currently increasing at a rate of 3% per year. During the second year, however,
it is expected to only grow at a rate of 1% before returning to the current 3%
growth rate.
·
The vacancy rate is expected
to climb to 7% during the following two years and then return to a stable 5%.
·
The terminal
capitalization rate of 9% is estimated from current market cap rates.
This
is the proforma cash flow statement under the given market assumptions. The
sales price in year 5 is year 6 NOI divided by the capitalization we can compute
the present value by discounting the future cash flows back to the present
using the investor’s required rate of return of 12%. The cash flows are
Rs. 104,500 in year 1, Rs.103,323 in year 2, Rs.106,423 in year 3, $111,973 in year 4,
and $1,435,241 (the sum of N.O.I. in year 5 and the expected resale value) in year
5. Therefore the subject value estimate is Rs.1,136,977.
Conclusion
In this article, we discussed the income approach to real estate valuation. We defined the income approach and then explained the two income approach methods appraisers use. First, the direct capitalization method uses a single year’s income to estimate the market value of a property. Second, the yield capitalization method uses a multi-year forecast of cash flows and then discounts these future cash flows back to the present in order to get a present value for the property. We then walked through an example of both the income approach using the direct capitalization method and another example using the yield capitalization method.
What Is The Income Capitalization Approach?
The income capitalization approach
is one of the three real estate valuation methods, the other two approaches
being the cost approach and the sales comparison
approach.
In
this article, we will discuss the following:
- Using the income capitalization approach for
determining a property’s market value.
- Pros and cons of using income capitalization approach.
- Other alternative methods.
Income
Capitalization Approach
The income capitalization approach
uses the income a property generates to determine its market value.
It’s also commonly referred to as
the income approach. The more income generated by the property, the higher its
value.
The income approach is usually used
in commercial real estate. For example, office buildings, apartment buildings,
and shopping centers.
This method isn’t recommended for
for-sale real estate investments such as condos, apartments, single-family
homes, land development, etc.
The income capitalization approach
formula is referred to as the IRV formula:
Net
Operating Income (I) / Capitalization Rate (R) = Property Market Value (V)
Before we get the actual value, we
have to do these three steps:
1.
Estimate
net operating income
2.
Determine
capitalization rate
3.
Apply
IRV formula
Estimating Net Operating Income
Real estate investors determine an
income-producing property’s fair market value based on the net operating income
(NOI) of the property.
The net income is the amount that
the property generated after all operating expenses are paid.
To have a close estimate, we need to
get the NOI from the monthly cash flow of a real estate property.
The appraiser must have access to
income and expense statements of the property for a more accurate calculation.
The formula would look like this:
Rental
Revenue – Rental Property Operating Expenses (mortgage, insurance, repairs,
property management, etc.) = Monthly Cash Flow
You can break down the formula for
net operating income (NOI) in four steps:
Estimate Potential Gross Income
Potential gross income is the income
expected from a property that has 100 percent occupancy. This is also assuming
that all occupancies are at market rent, lease rent, or both.
- Market Rent: usual rent charged for a particular space in the
marketplace
- Lease Rent: scheduled or contract rent
Potential gross income must include
all sources of income even those coming from laundry machines and rented
parking spaces (if there are any.)
Subtract Vacancy And Collection Loss
Based on the market and local area
of the property, an appraiser estimates the nonpayment of rent and periodic
vacancies. This determines the normal loss of income.
After you subtract the loss of
income from the potential gross income, you now have an effective gross income.
Estimate Operating Expenses
There are three types of building
expenses:
- Fixed: expenses that don’t get affected by a building’s
occupancy (e.g. property taxes, insurance, etc.)
- Variable: expenses affected by a building’s occupancy (e.g. snow
removal, utilities, management fees, etc.)
- Reserves: often called reserves for replacements, these are funds
reserved for items that have to be replaced periodically, not necessarily
on an annual basis (e.g. cooking stove, built-in appliances, etc.)
These expenses DO NOT include debt
services like mortgage payments and building depreciation.
Subtract All Expenses
Now that you have an estimate of
your operating expenses, you subtract these from your previously calculated
effective gross income.
The final amount is now your net
operating income (NOI).
Capitalization Rate
For the second step, we’re going to
find the capitalization rate.
The capitalization rate, also known
as the cap rate, is basically the return on investment. There are different
ways appraisers calculate cap rate. Usually, it’s found in market surveys.
For example, CBRE (NYSE: CBRE), analyzes average
cap rates for specific property types. CBRE releases a Cap Rate Survey twice a
year.
You could also ask a real estate
broker for guidance. They can provide you information on average cap rates in
your particular market.
The capitalization rate is a rate of
return on a real estate investment property. This estimates the expected
returns based on the property’s market price.
Cap rate excludes investment
property financing methods such as mortgage, hard money loan, etc.
There is no definite way to get the
exact cap rate. But if you have access to compare the sales of similar
properties, you could get an estimate with this formula:
Net
Operating Income (I) / Sales Price (V) = Cap Rate (R)
This cap rate formula can be applied
using the NOI and the sale price that you acquired from comparing similar
property values.
The result is supposed to be less
than one as the cap rate is a percentage.
Applying IRV Formula
Now that we have a value for our net
income (NOI) and cap rate, you can now use these to solve using the income
approach formula.
Net
Operating Income (I) / Capitalization Rate (R) = Property Market Value (V)
Cons
Of Income Capitalization Approach
There is no definite way to
determine the value of real estate as some values needed are based on market
prices that aren’t stagnant.
Experienced real estate investors
use different valuation methods that will come up with different numbers.
Even when you consistently use the
income capitalization method, you won’t end up with a definite value. The
number heavily relies on market data analysis.
Here
are some cons of the income capitalization method that you should be aware of:
- It’s difficult to calculate a definite value net
operating income even if the property is leased to a tenant. You can’t
accurately predict your rental income if your tenant doesn’t diligently
pay on time. Expect lapses in your cash flow that will affect your NOI.
- Second, maintenance costs are unpredictable. You cannot
properly take into account events such as earthquakes, fires, etc. that
can increase it.
- Capitalization rates are only estimated values. These
are based on market-average numbers and don’t take into account the
variables of the subject property. These particular variables can affect
property value.
- Property-specific factors also greatly affect property
valuation. For example, if a building is immediately in need of repairs,
it costs less than other buildings similar to the subject property.
Different lot sizes also affect property valuation.
Remember the income capitalization
approach can only give you an estimated value. You have to make proper
adjustments for any of the factors mentioned above.
Sales Comparison Approach
One of the ways to determine the
valuation of an investment property is the sales comparison approach.
This valuation method involves
looking at the sales number of real estate comparables (comps) to the subject
property. These comps must have a similar lot size, located in a similar area,
have the same number of bathrooms and bedrooms, etc.
This method will give you the most
accurate result in real estate appraisals as the numbers will rely heavily on
market data analysis of similar investment properties.
Cost Approach
Another one to consider is the cost
approach method.
Property valuation is based on the
cost of the land and the construction of the property.
For this approach, the value of a
property is equal to the cost of building a similar building minus the
depreciation.
This is used in select-use
properties such as schools and churches. Mostly for income-producing properties
and rarely for residential real estate. The cost approach method can also be
used on commercial real estate (especially if, for example, it’s a new office
building).
Conclusion
The income capitalization approach
might seem complicated but it’s a method that experienced investors usually
rely on.
You can only end up with an
estimated value. There will always be variables that will heavily affect the
price of your property.
A lot of the numbers heavily rely on
data analysis of similar properties. The real estate industry moves fast and
it’s best to approach an expert to get an accurate appraisal.
How to Calculate Property Value With Capitalization Rate= Value
Equals Net Operating Income Divided by Cap Rate
It's critical that real estate
agents and brokers who work with investor clients understand income property
valuation methods if they're going to do their jobs properly. A commonly used
valuation method combines income and the capitalization rate to determine the
current value of a property being considered for purchase.
In addition to a property's market
value, one of the first things you'll want to do as a real estate investor
who's considering buying a purchase is determine is its operating income and
costs. This information will tell you if the property meets your cash flow and
profitability goals and expectations.
The Capitalization Rate
Cap rate represents your anticipated
return after one year as if you had bought with cash. The understanding capitalisation rate is
vitally important to your future business growth, particularly if you're just
starting out.
Calculate Property
Value
First, determine the Net Operating Income(NOI) of your
subject property. The NOI of a rental property is its rents less its
expenses. Determine the net rental income after what it costs to maintain
the building if it's an apartment complex.
This can be a bit of a challenge
because you'll need the income and expense statements, and only the current
owner is likely to have this information. But you can also estimate NOI by
multiplying the sales price by the capitalization rate after you've nailed down
the cap rate.
A Calculation
Example
A six-unit apartment project might
yield Rs. 30,000 net profit from rentals. Determine the Capitalisation Rate from a recent, comparable,
sold property. Now divide that net operating income by the capitalization rate
to get the current value result.
Let's say your comparable sold for
Rs.250,000. You've determined that the property's NOI after deducting applicable
expenses is Rs. 50,000. Divide that by the $250,000 sales price. You have a
capitalization rate of 20%.
Assuming a capitalization rate of
20%, Rs.30,000 divided by that percentage is Rs.150,000. This would be the current
value.
Other Tools
.
Few properties are
purchased with cash and no financing, so another calculation method used might
be a cash-on-cash return.
There are books full of complicated
calculations you can use to value real estate and determine the performance of
real estate investments and rental property ownership and operations. Some
apply to wholesaling, some to fix-and-flip projects, while still others apply
to rental investing. Some are more useful to the rental investor in determining
the long-term performance of their portfolios.
Most investors only use half a dozen
or so of these calculations regularly for residential property investment.
Investment in
A whole new level of math is
involved in commercial investment. Lenders use some very specialized
calculations to determine whether to finance purchases or projects.
Choosing which valuation and profit
calculations to use depends on your goals and the property type. You probably
won't be all that interested in cap rate and other multi-family-oriented
calculations if you're an investor buying single-family rental properties.
Investment in
The beginning of a successful rental property
investment strategy is an accurate estimate rental yield for the
prospective property. The net rental yield tells you just how well your
investment is doing, not only with market factors and rent included, but also
with your costs, including management and maintenance.
The Bottom Line
Those who invest in real estate via income-producing properties should have a method to determine the value of any property they're considering buying. Cap rates are widely used in commercial and multi-family property valuation and profitability studies. They can be used to determine a good sales price, or the value of a listed property versus the asking price Sh Tweet
What is the Income Approach to Real Estate Valuation?
The income approach is
a valuation method used by commercial real estate appraisers to value an
investment property based on the amount of cash flow that it produces. It
can be used for any commercial property with rent-paying tenants, but it is
most common for apartments, office buildings, industrial properties, hotels,
and shopping centers.
The most commonly used
method of valuing a property using the income approach is the direct
capitalization method.
What is the Direct Capitalization Method?
To calculate value
using the direct capitalization method, there are two required input
variables—net operating income and the capitalization rate.
Net Operating Income (NOI) is calculated as a property’s Effective Gross Income
(EGI), which includes rental income and ancillary payments, minus Operating
Expenses. For example, if a property had EGI of $1,000,000 and operating
expenses of $500,000, the resulting Net Operating Income is $500,000.
A property’s capitalization rate is the rate of return that could be
expected on an all-cash purchase of the asset. The formula used to calculate it
is Net Operating Income divided by value. However, in the income
approach, the property’s value is unknown. As a proxy, investors may need to
view the market cap rate for the recent sales of comparable properties, and
make an estimate based on an average. For example, if there are three recent
sales of similar properties with a 6%, 6.5% and 6.75% cap rate, the average of
these three values is 6.41% and it could be defended as a logical choice.
With these two input
variables known, the property’s value can be calculated in three steps.
Steps to Calculating Value Using the Direct Capitalization
Method
With an understanding
of the required inputs, the three steps to calculating value are:
- Create a pro forma projection of income and expenses for the investment’s
proposed holding period, and use the pro forma to identify the property’s
stabilized Net Operating Income.
- Identify the appropriate real estate capitalization rate.
- Calculate the value using the
following equation: Net Operating Income / Capitalization Rate.
Using the example
above, $500,000 in Net Operating Income divided by a capitalization rate of
6.41% implies a sales price of $7.79M. While the calculation itself is
relatively simple, the logic and best practices that go into it are far more
complex.
Best Practices for Using the Direct Capitalization Method
The creation of a pro
forma—and the net operating income it projects—is part art and part science.
There are several best practices that should be considered by real estate
investors in this process:
·
Income estimates should
be based on actual leases and historical performance.
·
Income growth and lease
renewal rate assumptions should be conservative, in line with market trends,
and supported by data. For example, it would be unrealistic to assume that
income will grow at 10% per year unless there is actual data supporting this.
·
Pro forma expenses
should be based on historical performance combined with knowledge of existing
vendor contracts, property tax rates, and utility bills.
·
Expense growth
assumptions should be in line with historical inflation trends and they should make sense relative to the income
growth assumptions. For example, it would be unrealistic to assume 10% income
growth and no expense growth.
·
The chosen cap rate
should be fully supported by comparable sales data, and it should make sense in
the market. These rates should be easily verifiable using data services such as
CoStar or the like.
·
The chosen cap rate
should make sense relative to the risk-free rate (prevailing rate on the
10-year treasury). Investors should be appropriately compensated for the amount
of risk associated with the property relative to the 10-year treasury.
·
Vacancy assumptions
should be in line with historical performance and current market trends. For
example, if the market averages 10% vacancy, it may be unrealistic to believe
that the property could achieve 3% vacancy.
·
Finally, the cap rate
should only be applied to a stabilized net operating income. It should not
include typical one-time charges like lease termination fees or tax
incentives.
There is no “right”
value that results from using the income capitalization approach. Instead,
there is either a value that can be defended using market data, or there is a
value that cannot be defended at all. Ultimately, the property valuation
estimate will be proven right or wrong by the market, which will judge a
property as being appropriately priced or not.
It is however
important to note that nearly every purchase and sale transaction will require
a third-party appraisal, which will conclude its own independent market value.
The appraiser will likely use all three approaches to value, and his or her
conclusion will also serve to validate (or not) the investor’s own valuation
estimate.
Property Market Value =
Net Operating Income (NOI) / Capitalization Rate
As
you can see, this appraisal approach consists of two main variables: the
capitalization rate and the net operating income (NOI). So, here’s how to
calculate each of the components:
How to Calculate NOI
The net operating income is the monthly
cash flow an investment property generates multiplied by 12. So, if we were to
calculate the monthly cash flow of a rental property, it would look like this:
Rental Income – Rental Property Expenses (mortgage,
insurance, property management, etc.) = Monthly Cash Flow
Let’s
put this into action to make sure you got the idea:
You own a duplex that is
fully occupied and generates $1,500/unit/mo. You have a mortgage payment of
$800/mo., an insurance payment of $150/mo., and you manage your rental property
on your own, so that means you have no professional property
management fees. But you pay $100/mo. for landscaping services to a contractor.
What is the cash flow?
Cash
Flow = (1500*2) – ($800 + $150 + $100)
= $3000 – $1050 = $1950 positive
cash flow on a monthly basis.
So,
now, how do you calculate the NOI?
You multiply the cash
flow value by 12 because the NOI is the annual cash flow of an investment
property. $1950 * 12 = $23,400.
Determining Cap Rate
The capitalization rate is the second
component of the income capitalization
approach.
It is one of the return on investment metrics which estimate the expected
returns relative to the property’s market price. It excludes any investment property
financing methods you use (mortgage, hard money loan, etc.).
The
cap rate formula looks like this:
Cap Rate = NOI /
Property Value
To
demonstrate how it works, we’ll take the previous example and suppose that you
purchased the duplex for $200,000.
Cap Rate = $23,400 /
$200,000 = 0.117
(11.7%)
Notice, this example
includes a high cap rate property, which means it looks
like one that is profitable. Also, notice that we used the NOI in this formula
as well. Therefore, it means that the NOI is an important measure for all
return on investment and appraisal calculations.
However, not all cap
rate calculations are this simple. Sometimes, you’ll find real estate properties that have more variables which might
make the calculation more complicated. And when using the income capitalization
approach, it’s much easier to have readily calculated cap rates. Therefore,
you’ll need to use real estate investment tools and resources. A cap rate
calculator is the resource you’re looking for! Mashvisor’s cap rate calculator
has your back since it provides a real estate investor with readily calculated
cap rates that you can use for the income capitalization approach formula.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
So, you’ve learned the
many benefits of investing in real estate and decided to buy your first rental property. Not so fast! Just because there’s money to
be made in real estate, not every piece of real estate is profitable. Some
investment properties will even cost you more than they’ll make you. You don’t
want to end up in that situation right? This is why the most important aspect
of real estate investing that beginner investors must learn before jumping into
the industry is how to analyze investment opportunities.
Basically, this is the
process of running the numbers behind a potential real estate investment early
on to tell you if this deal has promise or not. There’s a number of metrics or
calculations that property investors use for analyzing rental properties, the
most common of which is the cap rate calculation. In this guide for beginner investors, we’ll
explain what the cap rate is, why it’s important, and how to calculate it.
Let’s get started!
First Things First: What’s Cap Rate in Real
Estate?
The cap rate (aka
capitalization rate) is commonly used in real estate to refer to the rate of return on a rental property. It is based on the net operating income
(NOI) that the property generates in relation to its current market value. A
real estate investor can use the cap rate calculation to either analyze a
certain deal or to compare different investment opportunities. For example, if
all else is equal, an investor is most likely to buy a property with a 10% cap
rate versus another with 3% cap rate.
In addition, the cap
rate is also understood as a measure of risk in real
estate investing. So, a higher cap
rate tells property investors that the investment is riskier and a lower cap
rate means an investment is less risky. Keep in mind that this is the same
principle that gives you a lower return on investment for low-risk assets than
for more risky assets. Meaning, while high cap rate properties can be riskier,
they also give a higher return on investment. Of course, this theory varies depending on
the type of property you’re looking at, its location as well as its condition.
But as a real estate
investor, you shouldn’t just pay attention to the potential returns or profit
from the rental property. You also have to estimate and protect yourself
against the possibility of losing money (risk). This is another reason why
the cap rate calculation is great for analyzing real estate opportunities as it
enables you to make investment decisions more confidently when you balance
risks and rewards.
As mentioned, the cap
rate is the ratio of a rental property’s net operating income to its market
value. If you’re not familiar with the NOI, it’s simply your annual rental
income generated by the property minus all operating expenses including management, taxes, vacancy,
insurance, repairs, HOA costs, etc.
It’s important to note
that the cap rate calculation does NOT take the financing
costs into account. This is because NOI does not include mortgage payments or
interest payments. Excluding debt is part of why the cap rate is so useful
to real estate investors. The assumption that the investment property is bought in cash
lets you focus on the property itself and its profitability instead of being
distracted by debt and financing. This also lets you better compare the risk of
one property (or market) to another.
Example of How to Calculate Cap Rate
You’re a real estate
investor looking to buy a rental property. You’ve saved up enough cash as you plan to
buy the investment property without taking out a mortgage. From reading this
blog, you remember that the cap rate calculation is an effective metric for evaluating
the profitability of rental properties. After searching in your local market,
you’ve found three properties for sale with their respective expenses, annual
rental income, and market values:
Factors Affecting Cap Rates in Real Estate
To decide if you’re getting a good cap rate and judge the risk of the real estate investment, you need to understand the three major factors that affect the cap rates of rental properties:
Economics and Demographics
The cap rate is
different in different cities and locations. Let’s say you want to buy an
investment property in a major city like Kolkata. It’s a big city with a strong economy and
has a high rental demand. At the same time, it has a lack of new supply because
of land shortage and regulatory restrictions. These economic and demographic
factors affect real estate values (i.e. higher property prices). For this reason, rental properties in San
Francisco have low cap rates, so investing here is less risky.
This means that real estate investors should be willing to accept lower returns
because of the lower perceived risk.
On the other hand, the
economic and demographic fundamentals of a small town housing market are
different. These locations are economically not as strong as major cities that
have diversified economies. Therefore, real estate investors will need to find properties with higher cap rates to compensate for the higher risk. This
also tells you that you should not use the cap rate calculation to compare
rental properties in different locations!
Local Real Estate Market
Cap rates are not just different between cities, but also between neighborhoods within a city. Remember, real estate is very local. For example, consider analyzing two properties in different neighborhoods – one is highly desired and has demand for rentals while the other is a run-down part of the city. You’ll notice that investment properties in the run-down part of the city have a higher cap rate, reflected by lower market values. On the other hand, a property located in the desired neighborhood would have a lower cap rate – reflected by higher market values. That doesn’t make it a bad place to invest in real estate! It’s only a matter of understanding risks and figuring out how to address
Type of Investment Property
Finally, to determine
if you’re getting a good cap rate, you also need to account for the type of
real estate property you’re investing in. For example, the cap
rate calculation will have lower
results for a residential real estate asset than a commercial one in the same
location. Likewise, multifamily homes are known to have lower cap rates than single-family home rentals. What’s the difference? Again, it all goes
back to risk.
During a recession, a
retail shop might go out of business, but people will still need to live
somewhere. Meaning, the residential rental property will likely remain occupied
and generate income even if rental rates are lower. The owner of the retail
shop, however, could face long vacancies. Thus, residential properties provide
lower cap rates because they have lower risks.
Moreover, even
residential property types have different cap rates. For example, multifamily homes and apartment buildings will generate
rental income from numerous tenants even if one tenant didn’t pay the rent for
the month. However, if you’re investing in a luxurious single-family home and
your tenant didn’t pay the rent, you’ll be left with no rental income that
month to cover your expenses. Higher risk = higher cap rate. This is why
investors should use the cap rate calculation to compare real estate properties of the
same type!
How to Find High Cap Rate Properties for Sale
Want an easy way to
find profitable investment properties for sale in the housing market without doing the cap rate calculation?
Mashvisor’s Property Finder allows you to do just that! With this tool, you
simply customize your search criteria through setting filters including your:
§ City
§ Budget
§ Preferred Rental Strategy (Traditional or
Airbnb)
§ Type of Investment Property
§ Number of Bedrooms and Bathrooms
From there, the
Property Finder Tool will give you a list of the highest cap rate properties
for sale in your selected city. And, after you’ve selected a few potential
properties, you can use the Investment Property Calculator to do a full property analysis to make
sure you’ll get a good return on investment!
Final Note on the Cap Rate Calculation
While the cap rate is important for analyzing
and comparing real estate investment opportunities, it’s only one of many
metrics to find the rate of return. So, property investors should use the cap rate
calculation together with others (like the gross rent multiplier and cash on cash return) to ensure making the right investment
decisions. To learn more about these, keep reading our real estate investment blog – it’ll teach you everything you need to start your real
estate investing career!