Capitalization rate explained

Capitalization rate explained

Capitalization Rate

Capitalization is an appraisal process to covert income streams to value.


How is it used? Commonly used for income producing properties.

The capitalization rate is a ratio used to estimate the value of real estate investments. A value estimate derived from a capitalization rate is considered a reliable estimate and it is used by real estate investors, commercial lenders and appraisers.

Variables affecting the capitalization rate: 1)It varies from market to market 2) It varies according to the different types of property 3) It changes with economic conditions.


Validating the capitalization rate:


A good investor or lender validates the capitalization rate utilized by the appraiser. Since the appraisal provides supporting statements explaining how the capitalization rate was derived, an educated consumer can use that information to make sure the final rate is accurate.


The following is an example of a property valuation using the cap rate:


Cash Flow Analysis for the Utopian Apartment Building

located at 1234 Main St. Anytown, FL.

This analysis retains the 1st Mortgage as per borrowers request

Gross Rental Income

(Less Vacancies)

Net Rental Income

Less Operating Expenses:

Taxes (from 1996 tax return)

Insurance (from 1996 tax return)

Utilities (from 1996 tax return)

Maintenance (from 1996 tax ret. and estimate)

LandScape (from 1996 tax returns)

Net Operating Income:

Debt Repayment:

Existing First Mortgage (Competing Bank.$300,000)

Our Facility ($500,000 at Prime + 2%)

Total Annual Debt Burden

$139,260

($6,963)

$132,297

($24,178)

($8,040)

($3,744)

($2,500)

($1,380)

$92,455

$60,000

56,650

$116,650

Using the Capitalization approach the value of the real estate is calculated the following way:

You obtain the Net Operating Income for the Property in the case of Utopian Apartments this is $92,455. After that you obtain the capitalization rate which is a combination of the interest that you will pay the Bank, and the required rate of return that you demand for your investment.

Assuming that 75% of the value of the building will be funded by a loan {with a 9.5% interest rate} and that the remaining 25% will be your investment {and you expect to make 10% return on it} . You would calculate the Capitalization rate as follows:

9.5% X .75% = 7.13

10% X .25% = 2.50

Cap. Rate 7.13 + 2.50 = 9.63%

Then it is a simple matter of dividing your Net Operating Income by your capitalization rate:

$92,455 divided by 9.63% = $960,072

This is the value of the building, and it is the most you should pay for it in order to obtain a 10% rate of return on your investment.

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