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ALL ABOUT REAL ESTATE INVESTMENT STRATEGIES
Overview of
Capitalization Rates Avoid shooting from the hip. . . using rules of thumb to establish value in investment real estate. Investment Value is a direct product of Net Operating Income (NOI). That being the case, it is imperative that an in-depth audit of income and expenses be conducted in order to insure an accurate NOI to project from. Once a reliable NOI has been established an reliable approach to value can be pursued. Avoid the use of elementary measures such as a Gross Rent Multiplier (GRM) in determining value, it deals only with the gross rent a property is assumed to generate and does not address expenses, debt service (principal & interest), or tax consequences. Let's take two almost identical side by side apartment properties. The gross income for both properties is the same. However, property "A" has separately metered utilities and separate heating units where all utilities and heating expense are paid by the tenants. In Property "B" the utilities and heating expense are paid by the property owner. Now does it make sense that an investor would pay as much for property "B" as they would for property "A". Of course not...so much for the use of GRM's in evaluating income properties. Continued below
While Cap Rates are also a preliminary approach to establishing value, the use of Cap Rates is a step toward reliability in establishing value. The term Cap Rate takes it's name from the capitalization approach to value. The capitalization approach is the process of converting Net Operating Income (NOI) (after expenses) to an estimate of value i.e., an NOI of $30,000.00 capitalized at 10 percent (NOI divided by a Cap Rate of 10 percent) would indicate a value of $300,000.00. A CAP Rate can be developed through the "Band of Investment" theory (too complicated to tackle here) or it can be extracted from the marketplace, that is the sale of comparable properties with similar risk. Generally speaking, a CAP Rate might be viewed as an investor's overall return adjusted for anticipated risk in the investment. The higher the risk in the investment (uncertainty in the income stream) the higher the return expected by the investor to compensate for the risk. Another way of putting it would be the higher the risk the higher the Cap Rate. For example, an investment property with a single credit worthy tenant with a 20 year NNN lease (triple net, tenant pays all taxes and expenses) might sell at a 8% Cap Rate. Reason? Little or no risk. A property with a less credit worthy tenant with a 5 year lease might sell at perhaps a 10% Cap Rate, and a multi-tenant property with 1 year leases might be likely to sell at a Cap Rate of 11 to 12 percent. An investment property where there were no leases to secure income, such as a motel operation with high business risk might be likely to sell at a Cap Rate from 15 to 20 percent. The cap rates stated here are intended as comparisons with risk, and in no way relate to Cap Rates in today’s market Keep in mind that these explanations are very general and are intended to demonstrate a very basic understanding of a Cap Rate approach to value. Keep in mind also that Cap Rates are not carved in stone. . .in a market where demand far exceeds supply of a certain type of income property, an investor might be inclined to pay a higher price (lower Cap Rate) for that in-demand property. The key in a Cap Rate approach to value is the accuracy of the Net Operating Income (NOI). While some consideration for risk might be factored into a Cap Rate decision, if the NOI is unreliable, the estimate of value will be considerably out of line. To ensure the reliability of the NOI, a thorough study of the property's income and expenses should be conducted in an effort to verify income and expenses. A CAP Rate approach to estimating value in an investment property does not take into account anything beyond the first year of the investment, and does not consider the impact of financing or tax consequences in the investment. Therefore, it should be viewed as a preliminary method of evaluation and is not to be interpreted as the "investment value" of an income producing property. Investment value can only be established by factoring in the impact of financing and tax consequences, calculating after-tax cash flows over an anticipated holding period. About the
author: Stewart L. Mac Donald, CCIM, is
President of Real Estate Assets, Inc., a consulting
services company focused on maximizing wealth through Asset
Management in the real estate portfolio. Mr. Mac
Donald has counseled on and has been an active participant in a
wide range of investment real estate projects. He has written
and presented seminars on "Strategic Planning in the
Investment Real Estate Portfolio" before bar associations,
financial planning and investment groups. | |
