Your office building is falling apart. The elevators don’t work. The lights keep flickering, and last Thursday, a fire broke out in the mail room. It turns out the electrical contractor used substandard wiring, in violation of city codes, and now the building inspector is kicking out all of the tenants until the building is re-wired.
Your landlord is losing money left and right. What’s it worth?
The income capitalization approach is the best valuation technique for income-producing properties that have been damaged, or whose value has been impaired by a legally compensable event. Its most common application involves commercial properties that are leased to business tenants and which thereby generate income through rental payments.
There are two income capitalization approaches: the direct capitalization technique, discussed here, and the discounted cash flow (DCF) model, which I’ll be discussing in my next blog.
The direct capitalization technique is based on a simple formula in which the net operating income (NOI) of a property in its first year is divided by the market capitalization rate cap (cap rate). The formula is expressed as:
Value = NOI / Cap Rate
That is, Value equals NOI divided by cap rate.
The difficulty lies in determining an accurate NOI and a valid cap rate.
Net Operating Income.
The NOI of a property is equal to the annual income produced by that property after deducting operating expenses. It requires three levels of data:
- Potential Gross Income (PGI), which consists of all the gross rents possible, and any other income the property potentially generates, such as parking fees, laundry fees, and vending receipts.
- Effective Gross Income (EGI), which consists of vacancy losses and collection losses.
- Operating Expenses, which consist of all operational, administrative, and maintenance costs, including utilities, insurance, repairs, and property taxes. However, operating expenses do not include debt service, depreciation, income taxes, and capital expenditures.
To calculate NOI, first calculate PGI; then apply these two equations:
PGI – Vacancy and Collection Losses = EGI
EGI – Operating Expenses = NOI
The simplified statement of these equations produces this formula:
NOI = PGI – Vacancy and Collection Losses – Operating Expenses
Let’s plug in some numbers using data from a hypothetical office building known as Trinity Tower.
Net Operating Income
Gross Rents Possible $175,000
Parking Fees $5,200
Tenant Signage Fees $2,450
Vacancy Costs $5,400
Collection Costs $950
Maintenance and Repairs $6,750
Property Taxes $24,100
Applying the data shown above, we now have the numerator for the direct capitalization formula, that is, the NOI for Trinity Tower. To determine the property value, we must next determine the market capitalization rate.
Market Capitalization Rate.
The market capitalization rate, or cap rate, is often well-known to investors and lenders in a particular market at any particular moment in time. It is generally based on market characteristics and trends (location, crime, property type, and other risk factors). The cap rate is used to estimate the value of income producing properties by reflecting the recent pattern of buyers and sellers in the same marketplace. If we knew the value (or asking price) of a property, and we knew its NOI, then we could modify the value formula, Value = NOI/Cap Rate to determine the cap rate. In other words, if Value = NOI/Cap Rate then Cap Rate = NOI /Value. Thus, using Trinity Tower’s NOI of $105,950, and a hypothetical asking price of $1,100,000, we can calculate the cap rate:
Cap Rate = NOI /Value
Cap Rate = $105,950 / $1,100,000
Cap Rate = 0.096
Therefore, the cap rate for Trinity Tower would be 9.6%.
This example assumes that we knew the value of the property. But what if the value of the property is what we’re trying to determine? What if the entire purpose of knowing the cap rate was to activate the first formula, Value = NOI/Value? In such a case, there are only two choices: either (1) apply a cap rate provided by a reliable investment source based on the most current information, or (2) establish your own cap rate based on bank lending terms and your desired return on equity (ROE). Let’s look at the second alternative.
To derive our own cap rate based on bank lending terms and ROE, we need to gather some data about the financing terms available to purchase the property in question. Let’s assume that a bank is willing to lend $800,000 at 6% interest to be repaid over 20 years. The annual debt service can be easily calculated using an online loan calculator. In this example, the monthly payments on a 20-year loan of $800,000 at 6% would come to $5,731.45. This converts to an annual debt service on the loan of $68,777.40.
Next, calculate the loan constant by dividing the annual debt service amount by the principal amount of the loan:
Loan Constant = Annual Debt Service / Loan Principal
(debt service divided by loan principal)
Loan Constant = $68,777.40 /$800,000
Loan Constant = 0.08597175
This produces a loan constant of approximately 8.6%, which is effectively the bank’s own cap rate for this transaction.
The next step is to determine the ROE. The general formula for ROE is Net Income divided by Shareholder’s Equity.
ROE = Net Income / Shareholder’s Equity
Let’s assume that a buyer in the marketplace would invest $50,000 toward the purchase of the subject property, from which he would expect to generate $7,500 per year in income. Applying the ROE formula, we can quickly determine that this buyer seeks a 15% pre-tax ROE:
ROE = $7,500 / $50,000
ROE = 0.15
In effect, 15 % is the investor’s equity cap rate.
We now have two cap rates, the bank’s loan constant of 8.6% and the investor’s ROE of 15%. In order to construct a market cap rate, we need to blend these two rates into one rate. To do this, we will need to determine the loan-to-value ratio (LTV).
The LTV ratio is simply a statement of how much a bank will lend a borrower against the appraised value of a property, expressed in the form of a percentage. It is stated in terms of the amount of money a borrower must borrow (his mortgage principal) divided by the appraised value of the property:
LTV = Mortgage Loan Amount / Appraised Property Value
In this case, the mortgage loan is $800,000, and the property value is stated at $1.1 million. Therefore, LTV = 73%. In effect, the bank will provide 73% of the financing for the property at its cap rate, and the equity market will provide the remainder at the ROE rate. To blend the rates, we effectively weight the rates according to the LTV percentages. The bank’s loan constant of 8.6% accounts for 73% of the market cap rate; therefore we multiply 0.086 x 0.73, which equals 0.06278. If the bank’s rate accounts for 73%, then the LTV for the equity cap rate is 27%. Therefore, we multiply the ROE of 15% by 27%, or 0.15 x 0.27, which equals 0.0405. By adding the two results (0.06278 and 0.0405), we arrive at a market cap rate of 0.10328, or 10.33%. Here’s a summary of the calculations:
- Bank’s cap rate (loan constant) = 8.6%
- Banks LTV debt ratio = 7.3%
- Bank’s weighted cap rate = (0.086 x 0.73)
- Investor’s cap rate (ROE) = 15%
- Investor’s LTV equity ratio = 27%
- Investor’s weighted cap rate = (0.15 x 0.27)
- Formula: MARKET CAP RATE = (0.086 x 0.73) + (0.15 x 0.27) = 0.10328, or 10.33%
Tying It All Together.
Let’s now return to the formula for the direct income capitalization approach: Value = NOI /Cap Rate. Since we know that the NOI is $105,950 and the market cap rate is 10.33%, we can now calculate the value of the Trinity Tower property:
Value = $105,950 / 0.1033 = $1,025,653.44
Therefore, we can now say that a property with a NOI of $105,950 in a market with a cap rate of 10.33% is worth $1,025,653.44.
The same formula can be recast to apply to investment decisions and to set the parameters in legal claims. For example, if Value = NOI / Cap Rate, then NOI/Cap Rate also equals the maximum purchase price a buyer should pay under current market conditions. Likewise, NOI/Cap Rate also equals the optimal amount of settlement or a judgment to be awarded for property damage or impaired property value, assuming that 100% liability has been established and that 100% of the property has been damaged or impaired. If a settlement or a judgment is based on a defendant who is 80% responsible for the impaired value of the property, based on a comparative negligence standard, then the final property value would be multiplied by 80% as follows:
Value (Based on defendant’s 80% liability) = NOI/Cap Rate
Another variation on the property value formula is to convert the cap rate to a cap factor and then multiply it by the NOI. To convert a cap rate to a cap factor (that is, a multiple), simply divide 1 by the cap rate. In this case, 1 divided by the cap rate of 10.33% is 1 / 0.1033, which equals approximately 9.68. With a cap factor of 9.68, the formula is simply stated:
Value = NOI x cap factor
Value = $105,950 x 9.68
Value = $1,025,596
The property value of $1,025,596 is quite close to the result obtained using the original cap rate formula above, the slight difference being attributable to the rounding of the cap factor.