Initially when a seller’s agent markets an income property for sale, the cap rate is presented as the annual yield from rental operations in relation to the seller’s asking price.
Yield is distinguished from profit. Both are stated as percentage figures; both represent a return on invested capital, typically the price paid for a property. However, a yield is the ongoing annual measure of net income generated by the operation of a rental property (residential or commercial). The yield a rental property produces is the property’s annual net operating income (NOI).
Profit, on the other hand, is the measure of gain realized over the entire period of ownership on the sale of property at a price greater than the price paid. Taxwise, profit is classified as a capital gain. It is calculated on a sale as the difference between the sales price and the price paid to acquire and improve the property, minus transaction costs. (Depreciation recapture is taxed at a higher rate than a capital gain).
Further, profit is a one-time event, taken on the sale of a capital asset. Conversely, yield is the annually continuing receipt of net operating income (passive or portfolio) calculated for each year of ownership of a rental property.
The seller’s application of the cap rate is the annual percentage yield the property’s NOI represents of their asking price. In other words, it is the percentage of the asking price the annual yield, or NOI, represents. The asking price is typically set first with the cap rate deduced based on the NOI, the reverse procedure from the buyer’s use of a cap rate.
The buyer and seller hold divergent desires with the cap rate. For a seller, the lower the cap rate the better, as a low cap rate means a higher selling price (and greater profit).
A buyer analyzes a property’s worth using a cap rate pre-established by the buyer. This analysis is based on the long-term outlook for the particular property. The cap rate the buyer establishes is applied to the property’s NOI to calculate the property’s present value. Thus, the buyer sets the maximum price to be paid to acquire the property based on the NOI, the NOI being confirmed prior to contracting (or closing) by a due diligence investigation of rents and expenses.
For a buyer, the higher the cap rate the better, as this means a lower purchase price (and greater yield).
When searching for income property to acquire, it is the buyer who makes the initial offer. Thus it is the buyer who needs to determine a cap rate sufficient to justify investment in each property under consideration. The rate for each property differs depending on the condition of the property improvements, the tenant demographics and location.
Settling on a cap rate without considering these conditions is financially unsound — unless the property’s land value is greater than the capitalized value of the income generated by what is then the property’s obsolete improvements.
For a buyer to find the value of a property, and further, the maximum price the buyer ought to pay to own it, the buyer first needs data on the property’s:
- gross operating income (GOI), equal to the annual rent amounts presently received from the property’s tenants and the scheduled rent amounts for vacant units after a vacancy factor reduction* (consider local demographic trends of population density and personal income as they influence future rental income);
- operating expenses, including taxes, insurance, maintenance, repairs/replacements and all other management costs — information which helps anticipate operating expenses includes the age, quality and care of the structure and components); and
- the capitalization rate the buyer devises as appropriate to evaluate property of its type and condition. [See firsttuesday Form 352]
*To calculate the vacancy factor reduction from scheduled income, start by obtaining the vacancy rate actually experienced by the property for the past year. If this is made unavailable, use an average for the area and property type (or disregard the property as not for sale due to a deliberate lack of known information). For example, a property has 50 units. On average, five units were vacant each month during the past year. Here, the property has a vacancy rate of 10%. Thus, include a figure of 10% in lost rents to set the anticipated GOI.
The first two factors allow the buyer and the buyer’s broker to find the property’s net operating income (NOI). To do this, you use the formula:
GOI – operating expenses = NOI
For instance, a new 10-unit residential rental property produces an annual bankable GOI of $120,000. The annual operating expenses likely to be experienced during the first year of ownership are $30,000. Therefore, the NOI is $90,000.
The NOI constitutes:
- a return of capital invested – mortgage and equity financing – used to purchase and improve the property (also called recovery of invested capital allocated to improvements, not land); and
- a return on capital invested (the taxable yield).
Mortgage interest and depreciation deductions and income taxes are separate personal issues of the owner, not a burden affecting rental income and operating expenses of the property.
On the buyer’s initial exposure to the property and gathering of its operating data — all the while ignoring the asking price and cap rate provided by the seller’s agent — the buyer next determines the rate of return (cap rate) acceptable to own this property in the future. Only when the buyer sets a sufficient cap rate — based in large part on the observed nature and condition of the property, tenants and location — can the maximum price to acquire the property be calculated (and then only if they have a verified NOI).
To calculate the purchase price your buyer will pay, you use the formula:
NOI / cap rate = purchase price
On the other side of negotiations, the seller does not use a cap rate to set the asking price. The seller’s thinking is to first set the price based on the amount they want for the property. It then becomes the task of the seller’s agent to extrapolate a cap rate for inclusion in their property’s marketing package. The formula the seller’s agent uses is:
NOI / asking price = cap rate
Here, the NOI is $90,000. The seller’s agent first introduces the cap rate concept of evaluation when marketing the property. In this case, the listing price the seller is asking is $1.3 million. With the price set by the seller and a reliable NOI known by the seller’s agent, mathematically $90,000 / $1,300,000 is 0.069. Expressed as a percentage (multiplied by 100), the cap rate is 6.9%.
If not, the price paid set using a cap rate based on today’s (or yesterday’s) historically low interest rates (reflecting low inflation and low real margins) will in real terms produce a loss for the buyer on a resale during the next two decades. Cap rates going forward will rise as they track increases in both mortgage rates and the demand for money when economic expansion begins (post-recovery) and we escape from the zero lower-bound interest rate trap of 2009-2014.
Very low cap rates for income property evaluation seem acceptable to impatient and inexperienced cash-heavy, interest-earning individuals with few investment opportunities. However, buyers and their agents need a discussion to contrast the coming years’ interest and cap rates with current rates.
6. What else need a buyer of income property consider in addition to the cap rate?
The cap rate does not reflect every aspect an investor needs to consider when setting the maximum price they will pay. Application of a cap rate formula alone does not account for:
- required renovation and rehabilitation of the property (which requires additional capital beyond the purchase price to eliminate the obsolescence);
- the cost of hiring a property manager and of other services needed to operate the property (when not included as an operating expense);
- a mortgage with an interest rate exceeding the combined rate of inflation and real return on investment used to set the cap rate; and
- a final/balloon payment in a mortgage.
Thus, a buyer purchasing a property subject to an existing mortgage or funded by a new mortgage needs to set the cap rate higher than the interest rate on the mortgage to justify the risk of loss. This spread covers items such as recovery of the investment or reserves for replacement, and risks presented by changes in demographic (tenant) demands. [See Card 7]
Editor’s note — Any adjustable rate mortgage (ARM) or due-date financing presents a particularly troublesome risk of loss due solely to future increases in interest rates — which of course reduce property values.
Further, the primary source of funds for the owner’s payment of a purchase-assist mortgage is the property’s NOI. The NOI remaining after deducting the interest paid on the mortgage represents the earnings attributable to the buyer’s cash equity investment. Thus, this remaining portion of NOI needs to produce a much higher percentage yield on the buyer’s leveraged equity investment (cash) to offset the risk of the buyer’s cash being subordinate to mortgage financing.
On the other hand, the practical, forward-looking buyer prudently makes an offer to buy a property only at a price based on the cap rate they have independently decided is applicable to this type of property and its condition. Thus, the buyer’s setting of the cap rate requires analysis of:
- a percentage annual real return on investment (ROI) the buyer is willing to accept, (say 3%-4%) on a long-term investment containing no risk of loss of invested capital, sometimes called a margin or profit margin;
- the annual anticipated rate of consumer inflation expected over the life of the investment (say 2%) needed to retain dollar purchasing power;
- a percentage annual recovery of invested capital or reserve for replacement of structural components, the annual return of the original investment allocated to improvements (say 2%, a 40-year recovery on 75% of investment allocated to improvements), comparable to income tax deductions from NOI for recovery of capital before income remaining is subjected to tax; and
- a percentage annual premium (say 0%-3%) for the risk of loss due to physical obsolescence of the structure resulting from age, any adverse demographics of personal income and population density (economic obsolescence), destruction of improvements due to uninsured casualty losses and other like risks unique to each property.
There are two types of risk to consider when determining the risk premium rate to be included in cap rates:
- risks inherent in the property (the primary category of risk); and
- risks due to human and other exterior activity (the secondary category of risk).
The primary category of risk considers the physical improvements on the property, including their deterioration and declining usefulness through aging, called physical obsolescence. Also labeled depreciation for tax accounting purposes, it provides for a return of capital (capital recovery) over the remaining economic life of the improvements before the land value exceeds the value of the property’s income, called economic obsolescence.
Depreciation is both an investment fundamental and a tax deduction. It is an annual allowance for the property’s “exhaustion, wear and tear and obsolescence,” as properly seen by the Internal Revenue Service (IRS). For investors, the allowance reserves annually a portion of the NOI, classifying it as a return of capital allocated to improvements. (At the same time, improvements made to a property as excessive maintenance expenses often increase the property’s value by allowing the owner to charge more rents).
The primary category of risk can be easily accounted for. However, the secondary category of risk is less tangible and therefore more difficult to translate into a percentage figure to develop the cap rate. Nonetheless, the primary and secondary categories of risk combined establish the risk premium part of the cap rate.
The secondary category of risk includes the “human” and exterior influences on the property’s value. These risks include:
- the creditworthiness and level of employment diversity in current tenants, an employer issue;
- the coming expiration of current leases, which are preferably staggered, a management issue;
- competition from nearby, similar property (existing and future construction), a market issue;
- a history of crime committed on or near the property, a security issue;
- long-term income and wealth changes in the area surrounding the property, ademographic issue; and
- changes in zoning, retrofitting, habitability and fire ordinances or regulations, a political issue. [See firsttuesday Form 185 Letter of Intent: Prospective Buyer’s Proposal for Due Diligence Investigations]
An example of demographic change can be seen in the changing attitudes about suburban versus urban living. Whereas the wide lawns and McMansions of suburban living used to call families by the droves, the amenities and jobs located in cities have caused a shift in housing preference among the next generation of first-time homebuyers, Generation Y. Thus, where a suburban income property earned high rents in the past, over the next decade rents are expected to decrease as demand of more skilled employees transfers to urban areas. Further, a decrease in demand reduces property values.
Zoning changes also affect a property’s rents, and in turn value.
For more on the tax elements of depreciation, see Realtipedia Volume 11: Tax Benefits of Homeownership Chapter 9: Depreciation and unrecaptured gain.
Current firsttuesday students may access Realtipedia from their Student Homepage.
For more on using the cap rate and net income multiplier, see Brokerage Reminder: Know the bottom line for investment properties.
For today’s mortgage rates and key interest rates, see Current market rates.
