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Capitalization Rate: Relationship of rental income to property value

Historic_home_in_Poplar_Lawn_Historic_District [1]A 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.