What's Your Income Property Worth? The Role of Cap Rates

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Author: Tony Seruga, Yolanda Seruga and Yolanda Bishop

Article source: http://www.articledeshboard.com/. Used with author's permission.

Capitalization rates, also called cap rates, are ratios used to determine an estimation of the value of properties that produce income. The cap rate is found by dividing net operating income by the sales price, or the value of a given property, when expressed as a percentage. When trying to determine the net operating income (NOI), the operating expenses and vacancy amount are subtracted from the gross income of the income property. Operating expenses may include maintenance and property management cost, utilities, cost of repairs and supplies, insurance and taxes, and advertising. For instance, a new roof, mortgage payments, or the purchase of a lawn mower would all be considered operating expenses.

Cap rates are commonly used by lenders, appraisers, and investors to decide what the purchase price for different types of income property should be. This number is considered a more reliable way to estimate value than the market Gross Rent Multiplier. This is because the cap rate includes more financial details for a piece of commercial real estate. While GRM calculations use only gross rents and the sale price to come to a conclusion, cap rate calculations incorporate not only rents and selling price, but also vacancy amounts, operating expenses, and non-rental income. The final value estimate made using a cap rate will thus be more accurate in the end.

From the perspective of an investor in income property, a higher cap rate is better, since that translates into a lower price. A larger return will be expected when the investment is in a high-risk piece of commercial real estate. Lower cap rates should be expected in a more desirable or newer part of a town or city. Higher cap rates will appear in areas that are considered less desirable. This compensates for the additional risk of investing in property that is less attractive because of the area's poor condition, undesirable location, or higher crime level. In general, in markets that have increasing net operating incomes and declining cap rates, the value will increase. When net operating incomes decrease and cap rates go up in a given market place, property values go down.

To find out the cap rate for particular types of income property in your prospective market, try talking to a lender or appraiser from the area. Remember that a given market might have a low sale frequency, meaning that it can be difficult to obtain accurate cap rate data. If you can get a market cap rate from someone in the area for a given type of income property, be certain to find out if that value was determined using data from recent sales of similar properties, or if it was constructed from analysis of component parts. This practice is sometimes used by appraisers when the correct financial data cannot be found, and results in a less credible rate. It is always better to use a cap rate that has been determined by evaluating recent buyer and seller actions in the local market. This produces the most reliable estimate of market value for a given income property. If you can obtain an accurate cap rate, you can then make use of the information to decide what comparable properties ought to be sold for. That will tell you if a particular income property is over or under priced in relation to others.

Keep in mind that the cap rate for an income property is only the projected return for a single year if the property is purchased with cash. It often does not take into account other factors, such as the return using particular types of financing. This means that the cap rate should not be used as the only method of deciding whether to purchase a piece of commercial real estate. The buyers should determine what the income property will be worth to them, based on investment goals and buying power. It is also important to make certain that the cap rate and the NOI it is determined from are accurate. As no two investors will operate a piece of commercial real estate in the same way, the NOI may not be accurate for a particular buyer. Finding out the components of this number will help the buyer make the right decision, based both on the cap rate and the particular situation. The cap rate of a given income property can be a very useful method of determining the sales price, but it should not be the only method used when deciding whether to buy.

Tony Seruga, Yolanda Seruga and Yolanda Bishop of www.maverickrei.com specialize in commercial and investment real estate. As of May, 2006, they and their partners are managing over $600 million dollars worth of new projects.