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Cap rate: What and how of it
Dec 10, 2007

In our previous article - DLF: Banking on REIT - we had mentioned about capitalisation rate (or ‘cap rate’) and how it is calculated. It was a brief explanation. In this article, we dwell more into the same and mainly because this is the most important aspect while calculating the market value of the property. What is a cap rate?
The cap rate is a ratio used to estimate the value of ‘income producing’ properties. Put simply, the cap rate is the net operating income (explained below) divided by the sales price of a property expressed as a percentage.

Why use cap rate?
Investors in real estate use cap rate to estimate the purchase price for different types of ‘income producing’ properties like commercial office space and retail properties. A cap rate is determined by evaluating the financial data of similar properties, which has recently been sold in the market. The cap rate calculation incorporates a property's selling price, gross rents, non-rental income, vacancy amount and operating expenses thus providing a more reliable estimate of value.

A buyer and a seller perspective
Assume there is a seller and a buyer for a particular property. The seller will try to get the highest price for the property or sell at the lowest cap rate possible. The buyer in turn will try to purchase the property at the lowest price possible, which translates into a higher cap rate. The lower the selling price the higher the cap rate and the higher the selling price, the lower the cap rate. In summary, from a buyer's perspective, the higher the cap rate, the better and from a sellers perspective, the lower the cap rate, the better.

The risk return trade off
Investors expect a high return when investing in high-risk income properties. The cap rate may vary in different areas of a city for many reasons such as desirability of location or general condition of an area. Investors would expect lower capitalisation rates in more desirable areas of a city and higher cap rates in less desirable areas to compensate for the added risk. In a real estate market where net operating incomes are increasing and cap rates are declining over time for a given type of investment property such as office buildings, values will be generally increasing. If net operating incomes (NOI) are decreasing and capitalisation rates are increasing over time in a given market place, property values will be declining.

Example: A property has a net operating income of Rs 200,000 and the selling price is Rs 2,000,000, cap rate will be -

Cap rate =Net Operating Income
               Market value

Cap rate = 200,000
               2,000,000

Cap rate = 10%

But what does this figure of 10% tell us? Does it tell what our return will be if we use financing? No. Does it take into account the different finance terms available to different investors? No. Then what does it show? What the cap rate above represents is merely the projected return for one year as if the property were bought with all cash. But remember, not many of us buy property for all cash, so we have to break the deal down to find the ‘cash’ return on our actual investment using debt. Then we calculate the debt service (interest payments), subtract it from the NOI, and calculate our return.

The generally accepted definition of NOI is

NOI = Gross Income – Operating expense

Operating expenses include the following items:

  • Advertising,
  • Insurance,

  • Maintenance,

  • Property taxes,

  • Property management,

  • Repairs, supplies, utilities.

Operating expenses do not include the following items;

  • Interest payments,
  • Income and capital gains tax,

  • Loan origination fees.

Note that operating expense does not include interest payment. Assuming that Interest expense in Rs 25,000, the NOI is Rs 200,000 – Rs 25,000 = Rs 175,000

Cap rate = 175,000
               2,000,000

Cap rate = 8.75%

No two individuals will own and operate a property the same way. It is completely possible for two people to look at the same property and come up with two different NOI and two different values. In a normal real estate market, most sellers do not expect the property to sell at the price they have asked and if the final market value is within a 10% +/- range, rather than getting into the figures it is advisable to get into the property and increase the operating efficiency thereby increasing NOI.

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