Four Kinds of Cap Rates: Will The Real One Please Stand Up?
Throughout the ages the value of income property has been affected by many different vogues (taxes, inflation hedge, replacement costs, etc.). These vogues come and they go. Ultimately, the value of income property is decided by the fact that income property is a business. Thus its value is determined by the bottom line. Bottom line earnings are the ultimate determining factor of value for income properties. However, as today we are without the benefits of excessive artificial returns created through tax deductions, bull markets resulting from long-term shortages of real estate, and excessive leverage from easy credit, earnings are more important than ever. The cap rate is how you measure the income property’s operating bottom line.
The capitalization rate is the income property’s yield on an all-cash basis. The rate is computed by dividing the net operating income (NOI) by a proposed market value (appraised, valued, purchased, or sales price). The value of an income property is computed by dividing the NOI by a proposed cap rate.
Net Gain believes the cap rate is the most important financial element for determining the value of income property. The influence of the present and future values of income property is so overwhelming that NetGain has made it the centerpiece of its National Income Property Index (NIPI).
The critical number for computing a cap rate is the NOI. This number is composed of two dollar amounts (income and operating expenses) that are subject to different interpretations and applications. Because these differences can have a profound affect on value, NetGain has decided to dedicate this article to explaining how these differences can happen.
Recently I had a conversation with the manager of a large pension fund. He proudly announced that he had purchased a trophy piece of real estate in a prime location at a six-plus cap rate. I congratulated him, and then I asked, “On what basis was the cap rate computed?” He returned my question with a blank stare.
The purchase was large, involving a great deal of money, and the key to determining the purchase price was the cap rate. Yet this pension fund manager didn’t know the assumptions behind his six-plus cap rate.
His stare went from blank to worried when I told him that the same property could have four or more cap rates. They are all valid; it just depends on the retirement program’s needs and financial objectives to determine which is appropriate to use.
By this time my pension fund manager was entitled to some sort of explanation. I reminded him that the key number to compute a cap rate is the net operating income (NOI). The following represents four different time frames that can be applied to one NOI number, each resulting in a different cap rate.
- Is the number being used last year’s NOI?
- Is the number being used last month’s NOI annualized?
- Is the number being used from a 12-month forward pro-forma?
- Is the number being used three months back added to three months forward and then annualized?
Pages: 1 2
I am a State Certified General Real Estate Appraiser with 32 years experience. I have never used your method(s) of developing a net income, unless it is the same as my statement below and your #3.
If you have an opportunity to read a good appraisal, the appraiser will spend a lot of time and effort in developing an “economic” rent rate for the property. And from that take out vacancy and expense factors to end up with a net income.
November 16th, 2008 at 12:38 pmThank you for your comment. The purpose of this article is to point out that the cap rate can be manipulated based upon the approach, and the closer you are to real net income numbers the better. Note that in our latest cap rate update we emphasize lease expirations. With or without an option, negotiation will most likely be in the lessee’s favor.
November 18th, 2008 at 3:04 pm