Capitalization Rate: Relationship of rental income to property value

Historic_home_in_Poplar_Lawn_Historic_DistrictA simple methodology to determine the value of investment real estate is necessary in many financial situations.  The value, generally, of business real estate can be determined using three different methods.

The simplest method is recent sales of comparable property (this method is also known as using “comps”).  This type of valuation can provide a good starting point and is widely used for appraisal purposes. It can have some shortcomings, in case where the market is changing rapidly or if there are unique attributes such as zoning or easements.

A second method is the replacement cost.  If there is property available and a similar building can be built for less than the asking price, a prospective buyer will choose to build rather than buy an existing building.

The third method, and the most accurate way to determine value, is the relationship between the rental income that can be generated by the property and the rate of return an investor will require.  Rental property is an investment and like all investments has risks.  The rate of return that an investor will require, is determined by this risk factor.  This “risk” drives the yield, or the return on investment, and is also known as a “capitalization rate”.

The capitalization rate is a simple calculation; the net income generated by the property divided by its market value equals the capitalization rate.

For example: assume a property generates $10,000 per year in net income (income received after all related rental costs) and the owner bought the property recently for $100,000.  The capitalization rate for this investment is 10%.  There are three variables in this equation; the rental income generated, the value of the property and the required capitalization rate (“cap” rate). If we know any two of the three we can calculate the third variable.

This same formula can be used to calculate the value of a building when we know the rental income generated.  A property generating $50,000 per year in net rental income and having a required cap rate of 8% means that an investor will pay $625,000 to purchase the property ($50,000/.08 = $625,000).  A different way to look at this calculation is that an investor will require a return on investment in 12.5 years.  At 8% per year return the investor will get back his or her entire investment in 12.5 years.

The average cap rate in 2014 for industrial property in the U.S. was 7.24%.  Investors will also consider a number of other variables when making this determination.  Anticipated increases in property values can help to offset required cap rates.  Real estate located in areas that are decreasing in value will cause an increase required cap rates.  Long-term stable tenants have less risk to an investor and thus will lower the required cap rates.

This is a simple tool that can be applied to many different situations.  Our clients many times will buy a building and become the landlord to their own business.  A rational approach to determine how much rent to charge is necessary.  We start with a calculation of cap rates and then modify this rent by any unique characteristics of the situation.  Other uses, such as insurance values, gifting and estate planning and financing are all influenced by this same measurement.

2 thoughts on “Capitalization Rate: Relationship of rental income to property value”

  1. Keith says:

    Can you further explain as to why a cap rates go up, a property valuation goes down, and vice-versa? This would seem counter-intuitive since a high cap rate would indicate that a property has more value to the prospective buyer.

    1. Steve Wisinski CPA CFE MAFF says:

      You have asked an excellent question, one that is very common to all investors.

      The capitalization is the risk rate for the landlord.
      A high risk rate, for the property owner, will mean either that the owner will want a higher rent or, if the rent is fixed in amount, will compensate by paying less for the property.

      If you have a strong tenant and want an 8% net yield on a piece of real estate you will pay 12.5 times the anticipated rent (12.5 x 8% = 100%).
      If the rent income is $20,000/year you will buy the building for $250,000 ($250,000 x 8% = $20,000 rent).

      If you have a marginal tenant you may want more of a return, say a 10% net yield. Now, for a property generating $20,000 annual rent, you will pay $200,000. A higher risk rate, given that the rent is fixed in amount, will cause a lower property value.

      The bond market operates in much the same way.
      An investment with a low risk, such as a U.S. Government bond can pay a low interest rate and still attract investors.
      Junk bonds have a much higher risk. The interest rates that they must pay will be higher.
      If the yields on bonds (or on rents for buildings) are fixed and cannot be adjusted, then the asset itself will go up or down accordingly to create this same yield.
      Higher risk will mean lower bond values.

      A fixed yield investment will go up or down inversely to the risk rate.
      It is counter-intuitive, but if you work out some sample amounts you will find that the logic is valid.

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