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By Joe Mueller

How should it effect your decisions when investing in rental property?  How is it calculated?  What do the numbers really mean?  Can it be manipulated?

A capitalization rate is defined simply as the ratio between a property’s net operating income and the property’s value.  This number is translated as a percentage that can be generally viewed as the rate you discount a property’s income to determine its value.  The capitalization rate, otherwise known as the “cap” rate, is a well-known equation used by almost all investors involved in commercial real estate.  The cap rate is figured as follows:

NET OPERATING INCOME  =         CAPITALIZATION RATE

VALUE (PRICE)

For review, the net operating income of a property is calculated by taking the GROSS SCHEDULED INCOME minus any VACANCY and CREDIT LOSS, giving you the EFFECTIVE GROSS INCOME.  This number is what you actually collect on a monthly or annual basis.  NET OPERATING INCOME is calculated by taking the EFFECTIVE GROSS INCOME minus all the expenses of a given property.  These expenses include everything associated with that property: gas, electric, taxes, insurance, management fees, etc.  These expenses are known as the OPERATING EXPENSES.  ANNUAL or MONTHLY DEBT SERVICE is NOT considered an expense when you are evaluating an investment property.  Factors like the amount of principal and interest paid monthly are important. But when evaluating an investment property, you must assume that most investors will need some form of a loan to purchase the property.  Since we cannot be sure what the loan balance, interest rate, down payment, amortization schedule, etc. are when formulating these calculations, we pretend we do not have mortgage or loan debt service.  This will give us the true numbers as if we purchased the property with cash.  After all the evaluating is done, loan payments can be computed to figure your BEFORE TAX CASHFLOW.  However, that is another article all together.

Why is the capitalization rate important? The cap rate is a general guideline that investors use when calculating the value for a property.  One can assume that with a cap rate of 10%, the investor is essentially receiving a 10% return on his monies invested.  Most investors are specifically looking for a minimum return when they purchase a piece of property, and a basic cap rate can be calculated very quickly.  The cap rate can tell the investor whether he should continue his evaluation of that particular property or move on to another.  In fact, a good number to use is 10%.  It is generally accepted that the majority of investors want to see a cap rate of at least 10%.  When I evaluate a piece of property, I look for a cap rate that is even higher.  Though more difficult to find, they do exist.

In addition, the cap rate is used as a determining factor when comparing similar properties that have recently sold or are currently for sale in a similar market.  If the building next door sold with a cap rate of 12% and is similar to the building you are considering to purchase, then you can figure out the cap rate and evaluate whether the asking price is good, bad, or ugly.  Let’s say the cap rate is 12%.  After doing a few quick calculations, you find that the property you have under contract has a cap rate of 15%.  Sounds like a good deal!  Your seller is either under-priced, or there are other factors that are creating that high cap rate.  Either way, one could assume that you are essentially paying less for something with the potential to generate a similar or higher return than the guy next door.

CAPITALIZATION RATE EXAMPLES

Office Building #1

Price (or Value):                       $500,000

Net Operating Income (NOI):   $65,000

Capitalization Rate:                   13%

Office Building #2

Price:                                        $625,000

NOI:                                        $73,000

Cap Rate:                                 11.7%

**Remember:  (NOI / Value = Cap Rate)

Which one would you find more lucrative for your real estate portfolio?  Though Building #2 generates a higher net income, #1 actually may be under priced and essentially creates a larger return at the current value .

Now let’s utilize the same formula to calculate the potential value of a property. Let’s say you own an apartment building that you are considering selling.  After consulting with a few area commercial real estate agents, you find that the going cap rate for the area the property is located in is 9.8%.  This is very important when calculating the value of your property because this is your baseline of value.  If you price your apartment building at exactly the going cap rate, you can expect to possibly sell the property for a price somewhere near your asking price- most likely within a similar market time that other properties have sold for in your area.  If the NOI for your building is $100,000/year, and you use a cap rate of 9.8%, your asking price would be approximately $1,020,400.  Take a look:

EXAMPLE:  Apartment Building

NOI:                                        $100,000 per year

CAP RATE:                             9.8%

ASKING PRICE:                    $1,020,400

**Remember:

NOI / Value = Cap Rate  (invert the formula)

NOI / Cap Rate = Value

But, let’s say you really need to sell this building.  The tenants are driving you nuts, the manager moved to Guatemala and isn’t coming back, and the maintenance is just becoming too much to handle.  What do you do?  Compute a new value based on a higher cap rate.  Once the building hits the open market at this higher cap rate, all the investors looking for a new property will jump on it after they compute the cap rate and find this potential deal.  Here is our new price:

EXAMPLE:  Apartment Building

NOI:                                        $100,000 per year

CAP RATE:                             12%

ASKING PRICE:                    $833,333

**Remember:

NOI / Value = Cap Rate  (invert the formula)

NOI / Cap Rate = Value

Why is this so important? Because an investor will see the potential equitable gain almost immediately.  Compared to other properties in the area, properties that generate just as much income as this one, it is priced almost $200K under the value it could be.  Does it sound too good to be true?  Maybe.  But some investors may need to sell right away.  Perhaps a new investment opportunity has come their way and they need to cash out of one of their properties.  What that means to you and me is that we can purchase this property for approximately 20% under market value.  Perhaps we can flip it for $100,000 profit and still leave some equity for the next guy.  Or we can just hold on to it, refinance, and cash out our down payment at the new value.  These potential opportunities are happening everyday in our Chicago market.  Consider the capitalization rate as a tool and one more weapon in your arsenal when hunting for a new piece of investment real estate.

To wrap it up, start evaluating any and all commercial real estate by utilizing the Capitalization Rate formula.  It is a good starting point when you first begin to evaluate whether or not a piece of investment property is for you.  Also, keep in mind that the majority of investors like to see a 10% cap rate when they purchase, so you should likely consider the same when you are making a purchase or wanting to sell.

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Joe Mueller is the Owner and Managing Broker for the TANIS Group LLC, a Residential and Commercial real estate brokerage based in the suburbs of Chicago.  Joe has been investing in real estate for over 8 years, and specializes in working with Commercial real estate purchases and sales.  His company can be reached at 847-594-4215, or via the Internet at www.tanisgroupllc.com.

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