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Multi-family units, office buildings, warehouses, retail strip malls and similar properties that generate rental and other income can be appraised using the capitalization rate approach.
This is especially helpful when you want to arrive at a rough listing or resale price quickly and easily. For example, when you want to suggest a price for a particular rental property based on the market cap rate or the client’s desired capitalization rate.
In this article, we will walk you through the process using a scenario situation. Let’s say a client asked you to suggest a selling price for their 8-unit apartment complex.
a) Determine net operating income
So you get it. Net operating income (or NOI) is one of the most important calculations made with respect to any real estate investment because it represents the property’s potential income after deducting all vacancies and operating expenses; Think of it as a measure of the investment property’s productivity, or cash flow.
When the property is financed, for example, the NOI represents the cash flow available to pay off the mortgage; If the investor pays all cash for the property, thereby eliminating the mortgage, this becomes annual cash flow (i.e., cash flow before taxes).
So, your first order of business is to determine the net operating income of the property.
Here’s the calculation.
gross scheduled income (GSI)
Underestimated vacancy and storage losses
= Effective Gross Income (EGI)
+ Income from other sources, such as late fees, vending machines, etc.
= Gross Operating Income (Government of India)
Lower annual operating expenses such as real estate taxes, utilities, insurance, maintenance and repairs, landscaping, management fees, legal and accounting, etc.
= Net Operating Income (NOI)
For our example, we’ll assume the income property has $54,000 GSI, $2,700 vacancy loss, $600 income from sources other than rent (i.e., coin operated washer and dryer), and $20,760 annual operating expenses.
$54,000 (GSI)
Cum 2,700 (Vacancy)
= $51,300 (EGI)
+ 600 (other income)
= $51,900 (Government of India)
Less 20,760 (Operating Expenses)
= $31,140 (NOI)
b) determine the desired rate of return
Next, we need to determine the capitalization rate we want to use for our calculations, using either of two approaches. Either we research the market for similar income properties to arrive at the market cap rate or we use the client’s desired rate.
For our example, we’ll assume that similar investment rental properties in our market area show an average cap rate of 6.23% and decide to use that rate instead with the seller. Keep in mind though, if the seller is adamant on using the rate they want, and it’s different from the market rate, we’ll side with the customer.
In other words, if our seller prefers to use a capitalization rate of 5.5%, we will calculate the value of his rental property based on that rate of return.
c) Calculate real estate value
Finally, now that we have the property’s net operating income of $31,140), and we plan to use a market rate of 6.23%, we can calculate our client’s income property value with this formula: Net Operating Income / Cap Rate = Real Estate Value, or $31,140 / 6.23% = $500,000
Ok, now you are ready to call your customer. Based on net operating income of $31,140 and a market cap rate of 6.23%, you estimate the market value of the client’s apartment complex to be $500,000.
Of course, for our purposes, we kept it simple. In a real-life situation, naturally, you’ll want to use reliable and accurate (not pie in the sky) numbers to arrive at a property’s NOI. In addition, you will also want to consider other factors that may affect the value of the property.
For example, the potential for an increase in rent, or the ability to add more units to a property will certainly increase its market value. Whereas, perhaps an impending zoning regulation that would make it a less desirable rental, and perhaps negatively impact rents or decrease occupancy levels, would cause its market value to decline. But you get the idea.
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