CAPITALIZATION RATES

The use of appreciation as a predictor of future value typically makes sense when the desirability of the subject property is based on something other than its rental income. For example, consider a single-user property such as a small retail building on a main thoroughfare. The owner of a business operating as a tenant in such a location is probably willing to spend more for the building than an investor would pay. In general, rate of appreciation as a predictor of future value may be appropriate when comparable sales work well as a measure of present value (i.e., "Commercial buildings on Main Street are selling for $200 per square foot by next year they will be up to $225."). However we as investors must use something called a Cap Rate.

CAPITALIZATION
With most other types of income-producing real estate, what you paid for the property is not likely to make much of an impression on a new buyer. Witness the rapid run-up and even faster collapse of prices in the late ‘80s. The typical investor will be interested in the income that the property can generate now and into the future. He or she is not buying a building so much as an income stream.

That investor is most likely to use capitalization of income as the method of estimating value. You have probably heard this referred to as a "Cap Rate" method. It assumes that an investment property’s value bears a direct relation to the property’s ability to throw off net income.

Mathematically, a property’s simple capitalization rate is the ratio between its net operating income (NOI) and its present value:

Cap. Rate = NOI/Present Value

Net operating income is the gross scheduled income less vacancy and credit loss and less operating expenses. Mortgage payments and depreciation are not considered operating expenses, so the NOI is essentially the net income that you might realize if you bought the property for all cash. If you purchase a property for $100,000 and have a NOI of $10,000, then your simple capitalization rate is 10%.

To use capitalization to predict value requires just a transposition of the formula:

Present Value = NOI/Cap. Rate

The projected value in any given year (i.e., the "present value" in that year) is equal to the expected NOI divided by the investor's required capitalization rate.

To use capitalization rate as a predictor of future value, in short, is to use this logic: "I am buying this property with the expectation that its net operating income will represent a return on my investment. It is reasonable to assume that whoever buys the property from me in the future will have a similar expectation. That new investor will probably be willing to purchase the property at a price that allows it to yield his or her desired rate of return (i.e., capitalization rate)."

EXAMPLE 1 A rental property will yield a NOI of $27,000, and the new buyer will require a 9% rate of return (capitalization rate), then you will estimate a resale price of $300,000.

EXAMPLE 2 The same property above is listed for 400,000 with the same NOI of 27,000 what is the Rate of return(CAP Rate)?

27,000 / 400,000 = 6.7% return

EXAMPLE 3 The same property boosted its NOI to 35,000 and the new buyer wants a 11% return on his investment what could he afford to pay?

35,000(NOI) / .11 (CAP) = $318,181

The same is true of your estimate of a new buyer’s required cap rate. Look at the investment from the new buyer’s point of view and remember that there are other opportunities competing for his dollar. Would you buy an office building with a projected cap rate of 9% if you could buy a bond that yields 8%? What if mutual funds are rocking and rolling at 15% and more? To attract a buyer, your property may need to be priced so that its cap rate is competitive. The higher the cap rate, the lower the price. In our example above, the property with the $27,000 NOI capitalized at 15% would be worth only $180,000.