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

 

 What Is the Income Capitalization Approach to Property

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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 P_n), 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

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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 Commercial Property

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 Rental Property

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:

1. 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.
2. Identify the appropriate real estate capitalization rate.
3. 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!