When you plan to invest in real estate, you will consider a lot more than the face value of the purchase price to determine the value of the investment. You will also look at the appraised value of the property, the comparative market analysis, or even the price per unit to determine if the property is a good investment for you.
The price, the appraisal, the market analysis, and the price per unit are all tools that will help you understand the value of the property itself, but, when you want to consider property value for the sake of investment, you will also need to know how much money that property can earn for you.
To find the investment value of the property, you need to consider the price of the investment in addition to the profits of the investment. Because there are many ways to do this, different investment fact sheets, brochures, private placement memorandums, and executive summaries may use different tools to present the investment’s value.
To help you have a clear understanding of the investment value when you see it, we will break down some of these valuation tools and explain how they compare to one another.
Each tool is a formulaic way to determine an investment’s value by comparing different investment variables. The resulting percentages can be easily compared with other investment opportunities to determine which investment is more valuable to the investor.
In this first part we will look at capitalization rates and cash-on-cash returns.
Capitalization Rate (Cap Rates):
Cap rates use the property’s price (or market value) and the property’s net operating income (NOI) to provide a valuation percentage. NOI takes into account all potential income and expenses the property will incur during the first year. Cap rates can help determine which party in a transaction has the advantage. Buyers have the advantage when the cap rate is high because that means the sales price is low compared to the expected profits. In contrast, sellers have the advantage when the cap rate is low because that usually means the profits have not increased at the same rate as the price of the property.
Capitalization Rate = Net Operating Income/Current Market Value
Negatives to cap rates: Cap rates only take into consideration the first year’s expected income. Furthermore, cap rates do not factor in debt or taxes on the property. Mortgage and tax payments will reduce annual income below the cap rate estimations. Cap rates will change frequently as the market value of the property fluctuates.
For example: A property purchased for $500,000 with an NOI of $25,000 for the first year will have a cap rate of 5%.
Cash-on-Cash Return (Yield or Rate-Of-Return):
Compares the cash invested with the first year’s before-tax cash flow. The cash invested includes the down payment, acquisition closing costs, and any initial repairs or upgrades made to the property. The before-tax cash flow considers all rent received, other income received, expenses paid, and debt service costs. Cash-on-cash return rates are effective because they are simple and can help investors compare not only real estate investments but other types of investments. They are also particularly helpful because they take debt into consideration and highlight the effect debt payments will have on cash yields.
Cash-on-Cash Return = Annual Before-Tax Cash Flow/Total Cash Invested
Negatives to cash-on-cash returns: Cash on cash returns only take into consideration the first year’s cash flow. Furthermore, they do not consider tax payments, which will decrease the actual rate of return depending on depreciation rates. In some cases, the annual cash flow amount can mislead the cash-on-cash rate of return if part of the cash received by the investor is a return of their original investment.
For example: A $500,000 property purchased with $250,000 in cash that had a $15,000 before-tax cash flow ($25,000 NOI - $10,000 paid in mortgage interest) would have a cash-on-cash return of 6%.
As we look into investment valuation further we will look at the other calculation tools such as: Internal Rate of Return, Gross Rent Multiplier, and Return On Investment.