How To Help Your Client to Use Capitalization Rates

Condominiums
Condominiums. iStockPhoto

Capitalization rates are a popular tool used by real estate investors in valuation of properties.  They are also used to help determine the proper listing and selling prices for commercial properties.  When working with real estate investor clients, agents and brokers need to be able to assist them in determining the justification for the asking price of income-producing properties.

Commercial and rental real estate for income generation rely upon cap rates to help in the evaluation of properties.

 Knowing the asking price and the capitalization rate of comparable properties will allow you to help your client to determine the net income that will be required in order to justify the price paid.  Not every investor is up to speed on cap rates, and you can demonstrate your value and expertise if you can help them to use cap rates for property pricing or valuation.

Difficulty: Easy

Time Required: 5 minutes

Here's How:

  1. Get the capitalization rate for comparable recently-sold properties in the area.
  2. Multiply the capitalization rate by the value of the property to determine the net operating income that would be needed to justify the price.

    Example: A cap rate for comparable apartment complexes is 12%, or .12, and asking price for the complex under purchase consideration is $300,000.

    $300,000 X .12 = $36,000 in net income that would be required to justify this asking price.

What You Need:

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    Those are the basics.  To help in understanding why cap rates are used by commercial property investors, let's look at the investment big picture for multi-family properties.

    Economy of scale:  Multi-family properties, particularly apartments, offer some cost reduction advantages due to economy of scale.

     With multiple units in one location and often under one roof, there are cost savings in everything from municipal services to repairs.  It's also much less expensive per unit to build apartments.

    Lessened effect of vacancy losses:  If you own a single family rental home and it's vacant for two months, you're losing 100% of your rental income.  If it's a duplex, it's 50%, and a four-plex is 25%.  But, if you own a 100 unit apartment complex, that one unit being vacant for two months is only losing you 1% per month in rental income!

    Lenders use Cap Rates:  When you're getting a mortgage on your personal home, it's all about your credit history and income.  When it comes to commercial lending, it's much more about net income and covering the mortgage payments.  There are usually multiple investor owners, and their credit scores are not even considered in most cases.  The financial performance of the property is the primary lender criteria.  If the property is in good condition and the numbers work, then the loan happens in most cases.

    So How Can Cap Rates Be Viewed?

    The thing is that the cap rate of a property has a lot of factors involved.  Particularly, the costs of management and operation, as well as prevailing rents, will determine the net income.

     So, if the rents are below market value or the expenses are higher than they need to be, the cap rate may not accurately reflect the value of the property.

    This is how bargains are uncovered by buyers.  Let's say that an apartment project owner has come to hate locating and interviewing new tenants.  This owner has been happy to depress rents to keep good paying tenants in the units.  So, rents could be well below what other tenants would be willing to pay now.  Buying the property and letting leases expire, raising rents and replacing tenants would change the net income a lot and the cap rate as well.

    On the other side, if the current owners don't watch their costs, expenses may be higher than they need to be.  Let's say that they are paying more than necessary for management, employee and repair expenses.

     Just bringing those expenses into line could make a huge difference.

    The lesson here is that cap rate is a measurement of performance, not a guarantee of value.  Check the rents and expenses for opportunity.