Capitalization Rate: True Value Or Complete Nonsense?

Real Estate | 3 Aug, 2011 |

Many real estate investors determine the value of an income property by using the capitalization rate, also known as the “cap rate.” However, this is absolutely the one most misused word and concept in real estate investing.

What is it? A real estate broker prices a business and its associated building by taking the Net Operating Income (NOI), dividing it by the sales price or, alternatively, the current market value; then you get the “published” capitalization rate.
While brokers, sellers and lenders are fond of quoting deals based on the cap rate, the way it is typically used, they really shortcut the true use of the real cap rate.
For example, let’s say the property has an NOI of $155,000, and the price is $1,155,000.
$155,000 / $1,155,000 = 13.4% cap rate

But what does that number really mean? Does it tell you what your return will be if you use financing? Absolutely not. Does it take into account the different finance terms available to different investors? Absolutely not. Then just what does it show?

What the cap rate above represents is merely the projected return for one year if this property were bought with all cash. Not a lot of us buy property for all cash, so we have to tear the deal down, piece by piece, to find the cash-on-cash return on our actual investment using leverage (debt).

Let’s calculate the debt service, subtract it from the NOI, and calculate the actual return. If the debt terms, loan-to-value (LTV), or our return requirements change, then the whole calculation must be performed again.

In order to correctly calculate a cap rate and get an accurate comparison, you must know the correct income and expenses for the property, making sure that the calculations of each were done in the same way as explained previously.

This information is not part of any public record. The only way to access the information would be to contact a principal or accountant in the transaction, and that’s typically hard to do because of confidentiality reasons. Serious brokers can typically get this done without a hitch.

So what do you do when you’ve found the property that looks great, and the listing broker tells you the cap rate is 13.4%, and you have to move on the property right away? How do you know if it is worth pursuing or if the cap rate is on the mark?

The real question is not how much I — or another investor, or even an appraiser — values a property at but, rather, it’s the value at which you can attain your investment goals that is reflective of your borrowing power. This will give you an intelligent starting point for the analysis.

If you learn how to do this, it will give you a leg up on 90 percent of the brokers and investors out there. Critical to this calculation is that the NOI is figured consistently with industry norms. The generally-accepted definition of NOI is:
Gross Income — Operating Expenses = NOI

The income and expenses must be verified.

In short, before accepting the NOI presented by the listing broker, understand what is behind the numbers. This is known as “normalizing” the numbers. You can also tweak the numbers to reflect the way you will own and manage the property.

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