Evaluating Investment Property
EVALUATING INVESTMENT PROPERTY: CAP RATES, CASH FLOW AND APPRECIATION
Many clients ask me to assist them in evaluating potential investment properties. One question that comes up repeatedly is “What is the correlation between the Cap Rate and Cash Flow”. My response is that, generally, they are not correlated; rather they measure different aspects of a property, each of which is useful to investors. And other factors, such as appreciation, should be taken into account before an investment decision is made.
First, the Capitalization Rate (CAP Rate) represents the percentage annual rate of return before mortgage payments and income taxes on the total investment. Cap Rates are primarily used to compare a property to similar ones in the market (both recently sold and for sale). The Cap Rate (CR) is a ratio calculated by dividing the annual Net Operating Income (NOI) before debt service by the market value (MV). The formula is CR = NOI ÷ MV.
For example, a duplex listed at $300K (the MV), with a NOI of $28K, based on gross operating income of $40K minus property taxes ($4K), insurance ($2K), owner-paid utilities ($2K), vacancy allowance ($2K) and anticipated maintenance ($2K), yields a Cap Rate of $28,000 ÷ $300,000 or 9.3%. Note that the NOI is determined, in part, by information provided by the seller.
The Cap Rate formula is a powerful tool. As we all learned in algebra class, if you know two of three values, the third can be calculated. For example, if you know the CR that you want to obtain and the NOI of a property you can determine the MV a specific Cap Rate and NOI support using this formula: MV = NOI ÷ CR. Similarly, you can determine the NOI required to for a property given a target Cap Rate and the listing price using this formula: NOI = CR x MV.
As the above examples illustrate, Cap Rates are very effective in evaluating one property against others in the market, but Cap Rates don’t tell us anything about what a property will earn on a month to month basis as NOI does not include the cost of capital, i.e., the debt service for principal and interest.. Additionally, depreciation and other tax benefits are ignored, as are capital improvements.
This is where a second tool, Cash Flow Analysis, helps investors: To determine estimated cash flow simply deduct from the NOI the debt service (principal and interest), add back in any tax benefits (such as depreciation), and factor in any special circumstances: Further consideration should be given to the tax advantages of real estate ownership, which are substantial (please consult your tax advisor), and to annual property appreciation rates.
Finally, both Cap Rates and Cash Flow Analysis are “snapshots” in time. Appreciation rates however are forward looking and should be part of your evaluation. Appreciation rates in the Olympia area real estate market are driving investors to accept lower Cap Rates (and lower monthly returns) in return for higher future property valuations. As an investor I must factor in appreciation to realistically evaluate Cap Rates and annual cash flow in order to see if the overall financial picture they reveal fit my investment goals. Fortunately, our market has experienced appreciation rates of 6-12% a year for several years and I see no reason to expect a slowdown. We are located directly in the growth path for western Washington, and recent market appreciation rates reflect that fact. So I recommend that you add an appreciation rate (both for future rents and market value) that you are comfortable with into your calculations and see what that does for the bottom line. I personally feel comfortable with 6% a year for the foreseeable future.