For years, the Capitalization Rate of an rental property has been the standard by which properties are analyzed and valued. However, the hypotheticals accompanying Cap Rates leave the door open for misguided investment; such misdirection may only enhance the bitter flavor of real estate succotash. Let’s be thorough because to do so will build a divide between the successful and the bellyachers. Now, how have Cap Rates served as masks of profitability? How can investing be more appropriately assessed? Let’s get started.
What is a Cap Rate? Cap Rate is assessed by taking the net operating income from a property and dividing by the value of said property.
CR = Net Operating Income / Property Value
Now, net operating income is, at best, an estimation and is supposed to be the income after fixed and variable costs are subtracted from the revenue (rent collected). However, these are often calculated poorly and do not represent the true net income on a property. In reality the Net Income is:
Rent Collected – (Loan Payments + Property Insurance + Maintenance Costs + Property Tax + Property Management Fees) = Pre Tax Income
Pre Tax Income – Income Tax = Net Income
One, or more, of these variables is typically left out and is not calculated with any income tax. Also, Loan Payments are not included in operating expenses; however, it is, in reality, the largest expense of owning and operating a business around income properties. Okay, let’s get specific; unless an investor is purchasing the income property with all cash, s/he is placing a downpayment as a means to secure an asset and a liability. The asset is the equity in the building + the revenue stream, and the liability is the payable amount on your loan (your loan payments). It is extremely important to weigh the quality of your asset against the burden of your liability. This is something a Cap Rate is simply incapable of consistently accomplishing. Furthermore, the Cap Rate is based around the value of a home, but it never actually interprets your initial cash outlay as the basis of the investment. The initial cash outlay is the downpayment + any other purchasing expenses (loan origination, attorney fees etc.).
When is Cap Rate useful? Cap Rate can be an appropriate and comprehensive figure that truly asses an income property’s strength, but typically in all cash purchases. That way, the figure is based around a true net income and a true cost (or value) of the property. What it still ignores is the effects of rent not collectable or late rent. Also, it assumes the asset is entirely liquid as if to judge it from an opportunity cost standpoint. I.E. the rate of return on the property as compared to a rate of return readily available elsewhere. However, most property is not purchased all cash, so the Cap Rate will have natural follies. Now, Cap Rates derived from your financing terms, initial equity investment, and loan amortization can provide a fair estimation of what the value of the property actually is to an individual investor. However, the figure still ignores variables such as tenant quality. So let’s get a bit more comprehensive, while not getting too finance-ish.
How should I value property? I call it “Pro Forma Analysis,” and essentially, it serves to encompass all financial variables, while observing the ramifications of deviating from what is expected as revenue. It is critical to know what financing terms are available to you in order to adequately approach this type of analysis, so get to a bank and figure that sucker out. Next, and this is a personal preference, I always base investment quality off of the amount of money in the pocket, meaning I include all forms of taxation into my estimations, never leaving my evaluation without considering after tax return. To the numbers:
You must know the exact initial cash outlay on the property, including downpayment on loan, legal fees, loan originations costs, and commissions paid. For example: A house purchased for $100,000 with a 20% downpayment, 1% loan origination fee, 1% legal fee, and a 5% commission that is split between buyer and seller.
Initial Cash Outlay = $20,000 + $1,000 + $1,000 +$2,500 = $24,500
Next, you must find out Cash Out-Flow which includes loan interest expense, property tax, association fees, prop management fees, maintenance, and insurance costs. The loan is interest-only at a 6% rate on an $80,000 loan, the property tax in the area is 1.5% of assessed value, the association fees are $300 annually, the maintenance is $1,200 annually, and the insurances total $300 annually.
Cash Out-Flow = $4,800 + $1,500 + $300 + $1,200 + $300 = $8,100 annual
Third, you must find your Cash Inflow at your estimated 100% occupancy/payments. This includes the rent income plus any other types of income the property may generate (parking etc.). In our example, the rent is estimated at $1,000/month.
Cash Inflow = $1,000 x 12months = $12,000 annually
Now, the investor must find the annual pretax income = cash inflow – cash outflow
Annual Pre-Tax Income = $12,000 – $8,100 = $3,900
The pre-tax return can now be calculated in terms of the initial cash outlay by dividing the pre-tax income by the initial cash outlay.
Pre-Tax Return = $3,900 / $24,500 = 15.9%
If your income tax rate is 20% than you actually only keep 80% of the income for all intensive purposes, so now the after tax return can be calculated by taking 80% of the $3,900 income and dividing by the initial cash outlay.
After Tax Return = (.8 x $3,900) / $24,000 = 13%
You have found that at your expected revenue, you will return 13% on a perpetual basis, and for these purposes, the figure is representative of a perpetuity because when sold, it will be sold as a perpetuity to the next investor. Regardless, these revenue streams, though they may change are calculated with perpetual return, and sold/priced as such.
You must recalculate the return when the revenue stream changes. The stream could change for multiple reasons, mainly vacancy, but there might also be a rent adjustment. Vacancy will affect expenses by removing some (maintenance) and adding others (advertising, etc.). The effects of vacancy and occupancy on expenses are highlighted in a Previous RentPost Article, so take a look to gauge those changes. It is important to note what expenses are fixed, regardless of occupancy; these are typically the largest cash outflows (Loan Interest, Property Tax); however, some things may dissipate, such as property management fees. You may mitigate your revenue by aligning different revenue streams next to one another. What are the effects if you are only able to secure 50% of the rent. If purchasing a single unit, and rent is not attainable at a given price, than you must lower the price in order to secure some type of income. Let’s say only $500 is attainable in a given year, but there is no effect on the costs, as the unit is still occupied. This suggests a cash inflow of $6,000 and the same outflow of $8,100, rendering a loss: ($2,100). As a percentage it is a loss of 8.5% annually. Lets try 75% of expected rent: $9,000 revenue. This leads to an after tax return of $720 – a 2.9% annual return. In fact, you must seek rent at a minimum of $675 dollars in order to break even. Comparing these figures side by side show that the risk of loss due to vacancy is significant. So, it’s a property that could potentially corrode your real estate portfolio, although initially it looked promising – 15.9% pre-tax return. How about this: the cap rate would have calculated out at just under 12%, as most agents would advertise. Sounds good at first, right? A cap-rate at 12% suggests the property is capable of “paying for itself”, or capitalizing, in 8.33 years. Wow! That could be catastrophically misleading.
In our discussed case, it shows how the strength of the asset is compared to the burden of the liability. Though treading through such an example could be insufferable, it assists in showing the ramifications if risks are recognized in real-estate investing. It is important to take note of every variable affecting the income to you by assessing your debt obligations and how your revenue stream stacks up against them. Now, this is not a final, entirely comprehensive approach to real-estate investing as a whole. Things differ: the loan may not be interest-only, in which you would be required to amortize the principal payments on the loan and adjust the interest expense accordingly, but trading perpetuities within 10-year horizons, is the best way to remain sustainable. In such a manner, I typically suggest interest-only loans, if attainable, as I see income-property investment as a means to purchase a stream of cash flows more than purchasing an actual piece of property. In that way, I can observe the property objectively as a cash-flow investment (which is what it is in all reality), and base the value of the investment off the stream of cash I own. The property/structure/land is only a conduit by which I asses a cash-flow, hardly even considering it as owned wholly by the investor – cause it ‘aint. Any sought after gain in value of the property will only increase property taxes, reduce liquidity, and sully the initial investment. Not to mention, the said “gain in value” would likely be corroded by capital gains tax and commission paid to the agent/broker. The “Pro Forma” approach is a more comprehensive one, allowing you to recognize the true value to you, while observing the consequences of deviating below your expectations from the property.