Determining your desired CAP Rate

Posted on August 14, 2010

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I was browsing through BiggerPockets forum and I came across a referral to an article explaining how to derive YOUR own CAP rate: What’s it Worth?- Deriving YOUR Capitalization Rate by Ray Alcorn.

Why would you want to derive your own CAP rate? Because the CAP rate is the most popular way to gauge the worth of an income property.

    CAP = NOI/(Property Value)

    Property Value = NOI/CAP

Thus, the property value is directly affected by the NOI and the CAP. After verifying the NOI, you can use “your” CAP rate to determine the maximum price you are willing to pay for the property.

Alcorn states that although the CAP rate is the most popular tool for evaluating properties, it is also the most misused.

Reasons:

  1. Most people compare properties to the market CAP. However, the market CAP rate is what the market is willing to pay for the property — the market is not always correct (i.e. the recent real estate bubble).
  2. The CAP rate is the “projected return for one year as if the property were bought with all cash”. Thus, CAP does not take financing into consideration.

The second reason is the more important reason why you want to calculate your own CAP rate. Different investors have different financial situations. Investors with better credit are able to achieve lower interest rates. Other investors with higher cash reserves can put in a larger down payment. Both larger down payments and lower interest rates provide smaller mortgage payments which allow for better cashflow. Thus for some investors the property is a deal, for other investors the property is not.

To calculate your desired CAP rate you need to know the terms of financing available to you and the return you want on your investment.

Here is the formula (for more detailed description go to Alcorn’s website):

    Loan Constant = Interest Rate /  [1 – (1 / (1 + interest rate ) ^ n) ]
    Equity Constant = desired COC

    Derived CAP Rate =  (LTV debt ratio x mortgage constant) + (LTV equity ratio x equity constant)

After calculating your desired CAP rate you need to calculate the NOI. When calculating the NOI, you can tweak the numbers to reflect the way you will own and manage the property. “No two investors will own and operate a property the same way.”

Next calculate your max offer for the Property:

    Property Value = NOI / derived CAP rate

Alcorn’s example:

    6.5% interest rate. 20 year amortization. LTV of 75%. Desired return of 20%. NOI of $125,000.

    Using a loan for $10,000 to calculate the loan constant:

    ADS = $894.72

    Loan constant = 894.72/10000 = 0.0895

    Equity constant = 0.20

    Derived CAP rate = 0.75 x 0.0895 + 0.25 x 0.20 = 0.1171

    Property Value = $125,000/0.1171 = $1,067,464

    So your maximum offer for an income property with NOI of $125,000 is $1,067,464.

The derived Property Value is a starting point. Many other factors influence the value of the property:

  1. Deferred maintenance
  2. Security of the income stream (strength of the tenants and length of the leases)
  3. Comparables in the area
  4. Market conditions

As the risk increases so does the investor’s required ROE or COC. I will write another blog post determining how to calculate your desired COC based on risk.

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Posted in: Analysis, Real Estate