Income Capitalization Method of Valuing a Rental Property

Income capitalization is a relatively sophisticated method of valuing a rental property. Yesterday, I posted about the easier Gross Rent Multiplier method. Capitalization of Income is one step above GRM.

Some people call this the NOI/cap rate analysis. It compares the Net Operating Income--NOI--to the value by using a "capitalization rate."

Here are some rules to remember:

• the tool looks at ONLY one year of revenue and expenses. That is its major drawback.
• that one year might be the last twelve months (trailing twelve NOI) or the last calendar year (calendar year NOI) or twelve months that will occur some time in the future (pro forma NOI)
• expenses are only "operating" expenses. In other words, you do not include mortgage payments (neither principal nor interest) or marketing or leasing commissions in the operating expenses. You do not include capital improvements, such as replacing a roof or re-paving a parking lot.

Conceptually, this is how you look at the analysis. If a buyer desired a certain annual rate of return on his money (looking at only one year), how much would he spend to acquire a property that yielded a particular net operating income?

In other words, if an investor were paying all cash, and wanted to earn 12% on his purchase price, what is the most he would spend to buy a property that generated $10,000 a year in NOI?  The 12% is the capitalization rate, or "cap rate" for short. We can think about is as being similar to interest. If an investor wanted to earn 12% interest on his money, and he could invest it in something that would pay $10,000 interest in one year, how much could he spend to buy that something?

This is a simple arithmetic problem.  You divide the $10,000 of NOI by the 12% cap rate (0.12) and the answer is $83,333.  If, many years ago, I put $83,333 in a savings account earning 12% interest, then I would earn exactly $10,000 in interest by the end of that year.  It is sort of the same thing.

Even though NOI does not include an item for mortgage payments, the cap rate takes mortgage interest rates into account. If it cost me 8% to borrow money to buy a property, would I be happy with a property that earned me 6% on my money?  Probably not. I would probably need a cap rate of 10% or more. There are technical ways to construct a cap rate, but they are beyond the scope of this post. Mostly, you talk to appraisers and bankers and investors in your market place, and find out where market cap rates are at the present time.

An appraiser might say, "For excellent quality brick apartments in good locations, fully leased up and mature, we are seeing cap rates in the neighborhood of 6%."  In other words, if the NOI is $100,000 for an apartment complex, then a recent sales price will probably be somewhere around $1,666,666. ($100,000 divided by 0.06)

That same appraiser might say, "For older apartment complexes in more marginal locations, with frequent tenant turnover and some collections problems, we are seeing cap rates in the neighborhood of 11%." In other words, if the NOI is $100,000 for that apartment complex, then a recent sales price will probably be somewhere around $909,090.

Both apartment complexes have exactly the same NOI.  The second one is worth $757,576 LESS than the first one, because it is not as desirable a property. It will have more management issues.  It does not have the status value of the first one, for people who want to own "nice" properties. The REITS will not buy the second one, so there is no easy exit strategy for an owner. The owner who is willing to buy the second complex will want a better return on his money.  The factor that accounts for that is the cap rate.

Think about this. If you could put cash in a 100% secure investment that would send you a check once a month with absolutely no management, what "interest rate" would you be happy with? Well, all the people who put money into Treasuries are happy with an interest rate around 1% per year.

If you are willing to put up with some headaches and some risk, you might want a better return on your money. You might want 4%.  If you are willing to put up with a lot of headaches and lot of risk, you want a larger reward. You might want to earn 15% on your money.  If you are willing to put your money into a slot machine, you might want a 1,000% reward.

It follows that the less desirable a property, the higher the cap rate will be.  People willing to buy that property want a better return on their money.  As you can tell from the example of the two apartment complexes that earn $100,000 a year, as the cap rate goes up, the value goes down.  If the NOI is exactly the same, but someone requires their investment to earn a higher "interest rate," then the purchase price has to be lower for that person.

That is how the capitalization method of valuing rental property works. In future posts, I will talk about:

• Why you might have to make adjustments to the accountant's Profit & Loss in order to calculate the true NOI. This is more than just excluding the mortgage interest.
• The differences among trailing twelve, calendar year and pro forma NOI, and how you can use this in negotiations.
• How you can use your understanding of the capitalization method to dramatically increase the value of your property by spending very little, or no, money.
• An even more sophisticated valuation tool called the Internal Rate of Return.

For a deeper understanding of these, and similar concepts, I highly recommend an excellent little book by Frank Gallinelli, "What Every Real Estate Investor Needs to Know About Cash Flow...And 36 Other Key Financial Measures."  It is less than $15 and absolutely priceless.  Mr. Gallinelli writes in a comfortable and chatty style that is often humorous and always very easy to read. Even if you HATE math and accounting and numbers, you'll enjoy his book and completely understand the financial concepts as you read about them.  When I taught Principles of Real Estate at the University of Alabama College of Commerce and Business Administration, I did not require my students to buy a textbook. I did recommend they buy Mr. Gallinelli's book. It's that good!