Financial Funding LLC Explains How a Capitalization Rate Works

Online, November 19, 2013 (Newswire.com) - What is a Capitalization Rate?

That is a question many people ask when dealing with a commercial property and the professionals at Financial Funding LLC would like to shed some light on this question for you.

Capitalization rate (or "cap rate") is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:

Capitalization Rate = annual net operating income / cost (or value).

A cap rate represents merely the projected return for one year as if the property were bought with cash. Not many of us buy property for all cash, so we have to break the deal down, to find the cash on cash return on the actual investment using leverage (debt).

Capitalization rates are an indirect measure of how fast an investment will pay for itself. Note that a real estate appraisal in the US uses net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income.

Use for Valuation

In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula below:

Capital Cost (asset price) = Net Operating Income / Capitalization Rate

One advantage of capitalization rate valuation is that it is separate from a "market-comparable" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to rebuild the structure in addition to the cost of the land and capitalization rates). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income properties, are usually compared to ensure that estimated revenue is being properly valued.

Cash flow defined

The cap rate is calculated using a measure of cash flow called net operating income (NOI), not net income. Generally, NOI is defined as income (earnings) before depreciation and interest expenses:

Net Operating Income (NOI) = net income - operating expenses (tax write-offs, i.e. depreciation and mortgage interest are not factored into NOI); whereas Cash Flow - Net Income (NOI) - Debt service. Financial Funding LLC analysts will require verification of the income and expenses, or all calculations that flow from them will be flawed.

Depreciation in the tax and accounting sense is excluded from the valuation of the asset, because it does not directly affect the cash generated by the asset. To arrive at a more careful and realistic definition, however, estimated annual maintenance expenses for capital expenditures will be included in the non-interest expenses.

Although NOI is the generally-accepted figure used for calculating cap rates (financing and depreciation are ignored), this is often referred to under various terms, including simply income.

Cap rates provide a tool for investors to use for roughly valuing a property based on its Net Operating Income. A comparatively lower cap rate for a property would indicate less risk associated with the investment (increasing demand for the product), and comparatively higher cap rate for a property might indicated more risk (reduced demand for a product). Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality and location of property and general volatility of the market.

No two investors will own and operate a property the same way. It is entirely possible for two investors to look at the same property and come up with two different NOI's and two widely divergent values, and both are right.

That is why Financial Funding LLC instructs the appraisers to provide comparable sales, replacement value, and the income approach as part of a three pronged method in estimating value. The appraiser makes the appraisal representative of the market conditions and the typical requirements of investors and lenders active in the market.

The third method, the income approach, is usually given the most weight. That method is also known as the "band of investment' method of estimating the present value of future cash flow. It addresses the return required on both equity and debt, and leads to what can be called a derived capitalization rate.

The analysts at Financial Funding LLC reviews the methods computed by the appraisers and may adjust the valuation by utilizing the income and expense figures provided to us by the sponsor.

Please feel free to contact Financial Funding LLC to discuss capitalization rates further and to assist you with all of the products that we have to offer. Please visit our website at www.financialfundingllc.com or give either Richard Tretsky or Todd Tretsky a call at 800-743-8895.