This performance measurement is referred to as the capitalization ratio, or cap rate, which is the ratio between net operating income and sales price. Like the other performance measurements, the cap rate is a relevant measurement, which means that a favourable cap rate in one market may be considered unfavourable in another market. The cap rate is calculated as follows:
Net operating income = capitalization rate / Sales price
The cap rate is an indicator of value that measures the conversion a single payment or a series of payments, such as in perpetuity, into a single value. The process of converting income into a single value then is what we refer to as capitalization. The cap rate captures this measurement in a single value. It is very similar to the yield on a financial instrument such as a certificate of deposit. In The Complete Guide to Buying and Selling Apartments (New Jersey: John Wiley & Sons, 2004), I discussed this crucial performance measurement at คอนโด กรุงเทพ length. Following is an excerpt from Chapter 4.
As you can see, this ratio is really a very simple calculation used to measure the relationship between the income generated by the property and the price it is being sold for. To help put this in a better perspective for you, let's refer back to the beginning of this chapter when we discussed certificates of deposits. We knew the value of a CD was calculated by its respective yield. The cap rate measures that exact same relationship!
Present value of CD = Income / Rate = $10,000 / $200,000 =.05
Or to look it on another way...
Rate = income / PV = $10,000 / $200,000 =.05 = 5%
Buying an apartment building as related to this equation is really no different, than buying a CD from your local bank. As an investor, you are willing to pay or invest a certain amount of capital in order to achieve a desired return. You know that the rates paid by banks for CDs will vary within a given range, let's say 4%-6%, so you will most likely shop around a little bit to find the most favourable rate. The same is true of apartment complexes. The rate paid, or yield on your investment, will vary within a given range, generally 8%-12%, depending on a variety of market conditions including supply and demand issues, the current interest rate environment, and tax implications imposed by local, state, and federal authorities.
Let's look at an example. We know that net operating income is derived by subtracting total operating expenses from gross income. If you were to pay all cash for an apartment building, then net operating income represents the portion of income that is yours to keep (before taxes and capital improvements), or the yield on your investment. If you were considering purchasing an apartment building that yielded $50,000 annually and the seller had an asking price of $800,000, should you buy it? Let's plug-in the numbers to our equation and find out.
Net operating income = $50,000
Sales price = $800,000
Cap rate = N.O.I. / price = $50,000 / $800,000 =.0625 = 6.25%
In this example, you can see that the asking price of $800,000 provides us with a yield of only 6.25%. Let's assume that comparable properties in this particular market are selling for cap rates of 10%. Armed with that knowledge, we can easily determine a more reasonable value for the property by solving for sales price as follows:
Cap rate = net operating income / price
Price = net operating income / cap rate = $50,000 /.10 = $500,000
So in this example, based on the limited information we have, we know the apartment is overpriced by $300,000. Understanding this simple, yet powerful equation is fundamental to properly assessing value. Armed with this knowledge, you can quickly determine if the asking price of an apartment building is reasonable.
The cap rate is one of the most important performance measurements available to investors. You can see by the example illustrated here that an investor who is unfamiliar with this key ratio could have potentially overpaid for the apartment building by an astonishing $300,000. I should add that you can't always rely on the advice or opinion of a real estate agent when it comes to analysing income- producing properties such as apartment buildings. Many good agents don't understand value any better than the average person. Unless agents specialize in multifamily or commercial property, they will most likely not truly understand the value of an income-producing asset. I've also met my share of agents who do work in this industry and who still don't understand value. My advice to you is to familiarize yourself with cap rates by looking at and analysing as many income-producing properties as you can. By doing so, you will be able to rely on your own judgment and not the opinions of others.
The cap rate is an important performance measurement to be used not only with apartment buildings, but with any kind of income-producing real estate. The cap rate is so important, in fact, that it is the premise on which one of three traditional appraisals methods are based.
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