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There are many articles posted about CAP rates, GRM and other methods of valuating a potential real estate investment.  But very little is offered other than the formulas.  Below you will find an overview of the various methods with their relative advantages and disadvantages.  Jason has the training and expertise in property valuation to accurately analyze a property and help you to make a sound investment decision!              

 

Gross Rent Multiplier  ( Price / Potential gross income )

 

Uses

  1. To quickly survey the market for opportunities (properties with a low price relative to market based gross potential rent).
  2. To value a property by using the gross rent multipliers (GRMs) of very similar properties within the same neighborhood or market area.

 

Advantages

  1. Very little information is required.
  2. The required information may be obtained easily and quickly.
  3. Within a homogeneous neighborhood or market area, most similar properties should have similar GRMs.
  4. Investors may be fairly familiar with the GRM, but if not, can quickly grasp the concept.

 

Disadvantages

  1. The GRM does not allow for most relevant investment factors, such as:
    • Appreciation or depreciation in future value
    • Operating expenses
    • Financial leverage or mortgage amortization
    • Income taxes
    • Risk
  2. Because the GRM is simple to use, there is a tendency to use it without regard to its limitations.
  3. It is difficult to find truly similar properties.
  4. Using the GRM to value an investment is similar to using the total sales of a corporation as a measure of value. (The corporation would have to be as profitable as the average corporation for such an estimate of value to be accurate.)

 

Capitalization Rate  ( Net Operating Income (NOI) / Price )

Uses

  1. Used in real estate appraisal as the basis for establishing value.
  2. Similar to uses of GRM.

 

Advantages

  1. The cap rate brings operating expenses into the analysis.
  2. It is well known because of its wide use in real estate appraisal.

 

Disadvantages

  1. It does not explicitly allow for most relevant investment factors, such as:
    • Appreciation or depreciation
    • Financial leverage or mortgage amortization
    • Income taxes
    • Risk
  2. Because it is simple to use, there is a tendency to use the cap rate in situations where it does not apply.
  3. May be inaccurate due to unaccounted or misstated expenses.

 

Cash on Cash  (Cash flow before taxes / Initial equity investment )

 

Uses

  1. Often used to calculate the length of time required to return the initial investment to the investor
  2. Yield estimate for short-lived investments with no change in value
  3. Cash on cash may be compared to the dividend on a stock, the interest payment on a bond, or the equity dividend rate used in real estate appraisal
  4. Yield estimate for an investment purchased for annual income, not appreciation (and assuming no depreciation)

 

Advantages

  1. Cash on cash is easy to use.
  2. Many investors are cash-oriented.
  3. Adjustments for vacancy and credit losses, operating expenses, and financing on the income from the property are included.

 

Disadvantages

  1. It does not allow for most of the relevant investment factors, such as:
    • Appreciation
    • Income taxes
    • Mortgage amortization
    • Risk
  2. It does not allow for meaningful comparisons among potential investments.
  3. The importance of many factors is obscured by the simplicity of the analysis.

 

VALUATION FOR COMMERCIAL INVESTMENT

 

Discounted Cash Flow Analysis (DCF)

In commercial real estate analysis, investors typically use the discount rate, or the cap rate, rather than rules of thumb. Investors use the discount rate because it allows them to discount future cash flows due to the timing of the cash flows (or the time value of money) and the uncertainty of the cash flows (or risk). Adjusting for time and risk can be difficult because all real estate investments are different.

 

Yield Versus Capitalization Rates

 

Internal Rate of Return (IRR)

 

The cap rate is often expressed as R = I / V, where I is the first year’s NOI, and V is the PV or purchase price. Using the following example, NOI for year one is $100,800 and increases 3 percent annually. If we capitalize this number by dividing it by the purchase price of $1,000,000, we get a cap rate of about 10 percent. Using the Cash Flow Model (on a before debt, before tax basis), an internal rate of return (IRR) of approximately 12 percent is achieved. The 2 percent difference between the discount rate and cap rate is the result of the increase in the annual income and the value of the property. The market value (sale price) of the property increased at 2.5 percent per year, but after sales costs of 4 percent, the realized growth was about 1.67 percent. To verify this, assume that the market value and the NOI of the example is expected to increase at 3 percent and that there are no sales costs. NOI for year one is $100,800 and dividing this number by $1,000,000 results in a cap rate of exactly 10.08 percent. Therefore, the IRR would be exactly 13.08 percent (10.08 percent cap rate plus 3 percent growth rate).

 

Calculate the IRR.

 

n     $________________

0   (1,000,000)
1   100,800
2   103,824
3   106,939
4   110,147
5   113,451 + 1,159,274

IRR = 13.08%

 

Investors should use caution when comparing cap rates for different properties because expectations about the growth rate of NOI after the first year differ.

 

The cap rate is not a rate of return on investment  (like the discount rate or IRR), because it does not explicitly consider annual cash flows and the change in value of the property. Investment analysis typically will project annual cash flows and the change in property value (the reversion cash flow) separately and apply the Cash Flow Model with net present value (NPV) (using a discount rate) or IRR measures of value. In using the discount rate, it is assumed that individual investors will discount cash flows at the rate of return offered by comparable, alternative investments. For this reason, the discount rate is sometimes referred to as the investor’s opportunity cost. Corporate investors typically use their weighted-average cost of capital as their discount rate. This rate is a combination of the corporation’s cost of capital raised from debt and equity.

 

To learn more about these methods or other more sophisticated valuation techniques, give Jason a call at 206-919-7643.

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