I R V. where I = Annual Net Income, R= Capitalization Rate and V= Value

Transcription

1 Income Approach to Valuation Capitalization (Cap Rates) the short version! Capitalization is the process of converting net income into a meaningful value that correlates net income to the value of the property. The mathematical formula is expressed: I R V where I = Annual Net Income, R= Capitalization Rate and V= Value For example, if a property s net operating income is $42,300 and the capitalization rate (often shortened to Cap Rate ) is 11%, the property s value is $384,545. ($42, $384,545) The capitalization rate is the rate of return an investor would expect to receive. Using the simplest format, if an investor puts $100 in the bank for one year and ends up with a net income of $5, the cap rate or return on investment is 5%. In the above example, if the investor is considering the purchase of a property with a net annual income of $42,300 and he or she expects to receive an 11% return, the maximum price (value) of the property is $384,545. If the investor is willing to accept a lower rate of return, more can be paid. If, for example, the investor would be satisfied with a 10% return, the maximum price (value) of the property is $423,000. ($42, $423,000) Value $100. $384,585. $423,000. Net Operating Income $5. $42,300. $42,300. Cap Rate 5% 11% 10% When attempting to establish a potential listing price using this method, the fundamental logic is the same. The listing licensee may use the annual net income to determine the value. The obvious challenge is selecting a capitalization rate to apply. There are a number of methods with varying degrees of complexity. Given most licensees are familiar with the Comparative Market Analysis, one comfortable approach will be to analyze sales of comparable properties to determine a realistic capitalization rate. This is called the direct comparison method. R I V where I = Annual Net Income V = Value (selling price) and R = Capitalization Rate For example, comparable A has annual net income of $52,000 and sold for $400,000. Comparable B has annual net income of $65,000 and sold for $485,000. Comparable C has annual net income of $72,000 and sold for $558,000.The licensee calculates the Cap Rates for these properties by dividing the net operating income by the value/sold price. Value $400,000. $485,000 $558,000 Net Operating Income $85,000 $52,000. $65,000 $72,000 Cap Rate 13.1% 13% 13.4% 12.9% If the annual income of the subject property to be listed is $85,000, the listing licensee could then apply an average 13.1% cap rate to determine a suggested listing price: $85, $648,850. Value $658,900. $400,000. $485,000 $558,000 Net Operating Income $85,000 $52,000. $65,000 $72,000 Cap Rate 13.1% 13% 12.8% 12.9% 1 P a g e

2 Capitalization (Cap Rates) Net Operating Income In order to complete the cap rate analysis, it may be necessary to calculate the net operating income. This involves simple subtraction. Starting with the gross income, subtract vacancies and unpaid rent to arrive at the effective gross income. From that, subtract fixed expenses, variable expenses, and reserves for replacements. Subject Property Comparable A Comparable B Comparable C Vacancies/Unpaid Rent $12,000 $7,000 $9,200 $10,000 Effective Gross Income $188,000 $115,000 $143,700 $159,000 Fixed Expenses $18,000 $11,000 $13,800 $15,000 Variable Expenses $60,000 $36,700 $45,900 $50,800 Reserves $25,000 $15,300 $19,000 $21,200 Net Operating Income $85,000 $52,000 $65,000 $72,000 Now test your understanding of cap rate by completing the following chart. Your ultimate objective is to end up with a suggested sales price (value) for the subject property. Subject Property Comparable A Comparable B Comparable C Gross Income $160,000 $97,600 $122,300 $135,200 Vacancies/Unpaid Rent $9,600 $5,600 $7,400 $8,000 Effective Gross Income Fixed Expenses $14,400 $8,800 $11,000 $12,000 Variable Expenses $48,000 $29,400 $36,700 $40,600 Reserves $20,000 $12,200 $15,200 $17,000 Net Operating Income Value $520,000. $658,300 $711,100 Net Operating Income. Cap Rate 2 P a g e

3 Gross Income Multiplier Using a gross income multiplier (GIM) will look much easier after working with cap rates! The key is to remember you are working with a multiplier and not a percent. We establish a ratio between the value of the property and the gross income with simple division divide the value by the income. Value $400,000. $485,000 $558,000 Gross Income Multiplier Averaging these three results gives us a comparable gross income multiplier of Multiplying the GIM times the gross income of the subject property gives us a suggested selling price of $648,000. Value $648,000 $400,000. $485,000 $558,000 Gross Income Multiplier Gross RENT Multiplier is calculated the same but uses only rental income! 3 P a g e

4 Test Your Understanding 1. Which of the following numbers is not required to calculate the gross income multiplier? a. Gross income b. Vacancy rate c. Sales price d. Gross effective income 2. Which of the following numbers is not included in the calculation of net operating income? a. Annual taxes b. Depreciation c. Vacancy rate d. Variable expenses 3. If a six unit apartment building has a gross income of $57,600 and the comparable GIM for the area is 14, what is the value of the building? a. $411,428 b. $243,000 c. $576,000 d. $806, An apartment building produces a net income of $43,200 per year. The investor paid $436,000 for the apartment building. What is the cap rate? a. 10% b. 11% c. 12% d. 13% 5. An apple orchard yields a net operating income of $28,000 per year. The owners are considering retiring and selling the orchard at a price that would net them $400,000. What rate of interest would they need to get to maintain an annual income of $24,000? a. 14.3% b. 12% c. 6% d. 8% 6. Jim wants to list his income property for sale. His rental income for a year is $68,000 and his total income is $72,000. He knows that the Gross Rent Multiplier for comparable properties is 6.1. What would be a good listing price based on the GRM? a. $432,000. b. $111,475. c. $414,800. d. $544, Sally has a five unit apartment building. Each apartment rents for $300 per month and she estimates she will lose 6% per year due to vacancies and unpaid rent. Additional income is $1500 per year from vending machines in the building. What is Sally s gross effective income? a. $19,500 b. $18,420. c. $18,330. d. $18,000 4 P a g e

5 8. Pete has a seller client with a multiunit yielding a net operating income of $32,000. Pete s research shows that similar buildings are producing a cap rate of 6.3%. Based on this comparable cap rate, Pete should recommend a listing price of a. $201,600 b. $507,900. c. $571,500. d. $320, When calculating net operating income, fixed expenses include: a. Utilities. b. Property management fees. c. Insurance. d. Reserves for replacements. 10. Considering only cap rates, which of the following multiunits would be the best investment for your buyer client: a. Five unit, net operating income $21,600, sales price $432,000. b. Six unit, net operating income $27,000, sales price $675,000. c. Four unit, net operating income $18,000, sales price $375,000. d. Eight unit, net operating income $35,000, sales price $1,900,000. Bonus with regards to question 10, what other considerations are there besides cap rate? ANSWERS: 1-B, 2- B, 3- D, 4-A, 5-C, 6-C, 7-C, 8-B, 9-C, 10-A 5 P a g e