I can’t remeber which “guru” said this in one of the teleseminars on this site but is it true that for every $1 you can increase NOI the value of the property increases by $10?
If you are dealing 10% profits…sounds like Sheets.
Keith
I not quite sure I understand your post kdhastedt…?
The guru is simply stating basic math/finance. Remember the formula value = NOI/cap rate. Cap rate is just a discount rate that the market demands to attract investment into income producing property (simplified definition). A discount rate can further be implied as a profit expectation. Therefore if an investor requires a 10% return on his money dividing the additional $1 of NOI by this profit requirement equates to an increase in value of $10. It is important to remember that profit requirements and hence cap rates are determined by the market, therefore cap rates will vary by market. So that extra $1 of NOI might be worth $10 in New York but only $8 in South Dakota. This is the fundamental principal of increasing a property’s market value by increasing the rents.
I would add one point. Do not get confused because a discount rate is not a cap rate. It is a major misconception in the industry at large. A cap rate consists of: cost of financing, equity return (cash on cash), selling expenses and growth rate on a weighted basis. By doing the former it allows you to capitalize one period of NOI to a present value. A discount rate is the rate at which you discount the yearly cash flows (NOI) from operations to a present value. There is also a reversion rate which is the rate at which the sale price is discounted to a present value.
I would recommend using the discounted cash flow approach if you are looking at a property that is not stabilized when you buy it. Stablized means that the cash flows are not fluctuating drastically year to year. Using a cap rate in that situation, will give you a flawed value.
Also too, the 10% rule which is what that gentleman was using is another flawed approach. The reason it is used so much is simply because it is easy to calculate value on the run. A cap rate of 10% is rarely the case.
Outstanding post Sean.
Yes Sean, that is a good explaination. I have seen commercial real estate appraisers use a discounted cash flow analysis to estimate current value. The analysis discounts the yearly NOI during the holding period to a present value. To this is added the discounted reversion value from the ultimate sale of the property. The estimated sale price being the stabilized NOI divided by an estimated market cap rate.
+Discounted NOI (during holding period)
+Discounted Reversion Value (ultimate sale)
=Current Estimated Value
Thanks
Sean,
A cap rate consists of: cost of financing, equity return (cash on cash), selling expenses and growth rate on a weighted basis. By doing the former it allows you to capitalize one period of NOI to a present value.
I don’t understand this statement. I thought cap rate was defined as NOI/value. When you say “cost of financing” are you referring to closing costs, bank fees, etc associated with any loans as opposed to the principal and interest? Clearly, principal and interest are not included in the cap rate formula. Also, where does “growth rate on a weighted basis” enter the cap rate formula and what does that really mean? Are you projecting a future value for NOI as opposed to using the current value? Finally, if you simply use the present NOI in the formula, doesn’t that theoretically give you present value of the property? Aren’t we interested in the present values if we are using cap rate as a screening tool? What am I missing here?
Are you talking more about a cap rate as it applies to an appraisal than a cap rate an investor would use for the purposes of screening a property for a possible purchase? Surely, no one would use cap rate as the basis for purchasing a property. I know I wouldn’t!
Thanks,
Mike
Mike,
What I understood that as (maybe I’m wrong) is those factors having an influence on the market, thus the market cap rates. When deriving a cap rate out of thin air, without any accurate comps to compare “NOI/ Values,” the cost of financing does play a role in the cap rate (Band of Investments Technique). That’s the only time financing has an effect in appraising.
If your purchasing a property with unstable income (hotels are a good example), you wouldn’t want to make a purchase based on the current income because it could change very rapidly in the future. Instead of a cap rate (direct capitalization) you’d be better off using a discount rate (yield capitalization) to get the present value of future income based off of past income.
That’s over my head. Maybe I better buy a good book on appraisals.
Mike
I probably wen to in depth in the previous. A capitalization rate is like a WACC in a corporation. A WACC (weighted average cost of capital) is composed of all the different costs involved with that capital in a corporation on a weighted basis. A cap rate is exactly the same thing but in real estate. Mortgage’s cost money, Cash on Cash (equity return), Growth in investment value, and selling expenses. All the former either cost me money or make me money as a percentage of the total investment.
E.X
Loan Int - 7.75% x .80(LTV) = 6.20%
Cash on Cash (My return on equity) - 10% x .20(LTV) = 2%
Growth/loss in value - 2% per year @ 5yrs = 10.4%
Selling Expences = 6%
6.20% + 2.00% +((1.10408 x (1-.06))-1) = 11.98% cap (you can add equity build from ammortization too)
If you are not considering all these factors when buying commercial real estate, you may want to check if you are making money at all and how much. I can tell you appraisers don’t build cap rates because they don’t have to because, they figure you the investor know what is right for you, and the appraiser will bracket the comp sales cap rates around the cap rate your buying at. Unless its just unreasonable.
P.S. Had equation written wrong!
That's over my head. Maybe I better buy a good book on appraisals.Mike
Check with the local community colleges on apprasial continuing education/ qualifying education courses. Just a book by itself will be like teaching yourself mandarin chinese. I took a week long class (40 hrs) just to learn the basics of direct and yield capitalization. It’s not easy to learn.
Can anyone suggest a book or two that would be a primer on this subject? Sounds like I need a little more education. Thanks
Steve
On yield cap. or all income capitalization?
I would say one or two suggestions on both. I thought I had a working knowledge of both but your discussion has opened up my eyes to learning more. I recently purchased an office building to house my office along with others and the appraisal process shed a whole new light on the various ways of analyzing property. I would like to learn more because I am ready to go after building number 2. Thanks, Steve
I have several books from the Appraisal Institute. http://www.appraisalinstitute.org/ecom/publications/Books.asp?Books=All&Session=False
However the one I find myself referring too the most is called “Capitalization Theory and Techniques” by Charles B. Akerson, MAI. It’s a wire-bound book with all the charts and information on how to use them to work with yield capitalization. By the way, if you don’t have the charts or the magical formulas to punch into a calculator, you can’t do yield capitalization. It also touches on the residual techniques in direct cap.
“Fundamentals of Real Estate Appraisal” by William L. Ventolo, Jr. and Martha R. Williams is a basic book that covers all appraisal methods. The income cap. section I thought was very good for teaching the basics for both direct and yield cap. The Appraisal Institute doesn’t sell this one.
I have a yield cap excel spreadsheet you guys can have. Email me and I’ll send the file.
I would recommend this book for beginners. This book describes every aspect of appraisal. I would understand these concepts before moving into discounted cash flow analysis and capitalization. These subjects are done over in this book as well but are not covered as in depth as the formentioned book by danny.
Good Luck!
Appraisal of Real Estate
Twelfth edition
Publisher: Appraisal Institute
Once again Johnny digs up an old thread just to cut and paste info into it… :rolleyes