Capitalization Rate–A Not Quite as Quick but a Little More Accurate Comparison of REI

In our last article, I wrote about Gross Rent Multiplier as a quick and dirty method to compare potential real estate investments (plus reasons why it may not work in Canada) and the substantial limitations of using GRM. For the most part, I suggested that GRM be used as a way to quickly sort out investments that are of no interest and those that might be worth further investigation. Of those that merit further investigation, an evaluation using capitalization rates is useful.Capitalization rate will tell you what percentage of the property’s purchase costs you’ll earn back each year. So, the higher the cap rate, the better. It’s calculated as follows:

Net Operating Income Purchase Costs

=

Capitalization Rate

That’s pretty simple, so we should be able to get this in about 3 seconds–that is, after calculating NOI and purchase costs. NOI, or net operating income, is the gross rent less operating expenses. Operating expenses are all expenses associated with a rental property, such as insurance, property taxes, maintenance costs, vacancy allowance and any other operating costs (here’s where I trail off listing a bunch of expenses that may or may not have any application to a given RE investment: management costs, credit loss, legal fees; here’s where I start making things up: document prep fees, travertine replacement allowance, TWA SEO consultant fees), but excluding the mortgage payments. Purchase Costs include the price of the property and rehab costs.

Breaking it Down–Net Operating Income

OK, the expense part’s a bit daunting, but it’s really not that difficult. One approach is to shortcut the process by using a fixed percentage of gross rents to calculate operating expenses. I’ve seen suggested ranges of operating expenses being anywhere from 30-45% of gross rents. I have to say, I like the idea of shortcutting, but this one, not so much. It kind of defeats the purpose of using capitalization rates to go a little beyond GRM as a method of comparison. If you use a fixed percentage of gross rents, it suggests there is no difference in costs between properties, so you’re right back to one of the limitations of using GRM–that is, not considering operating cost differences between one investment versus another.

And I don’t think this reflects reality. For example, there are differences in operating costs as a percentage of rent between different types of properties–such as single-family homes versus multifamily or older homes versus new ones. Even among similar properties, we are finding significant expense differences right now with property taxes. Due to the wacky prices people have been paying for homes, taxing authorities have been more than happy to jump on the bandwagon and set the tax assessed value of the homes at their most recent sale price. For properties purchased (or, more so, built) over the last three to five years, the tax assessed values have gotten particularly off the beam.

As a result, when we look at potential investments, we’re making a run at calculating actual expenses that we can know up front, such as insurance (get a quote), taxes (mostly available online at sites like this one), and HOA fees (contact the association or heck, ask a neighbor), and using a standard allowance for vacancy and maintenance and repairs. For now, we’re only looking at single-family homes, mostly built within the last 10 years or so, so standardizing vacancy and maintenance costs probably has some validity. Give us a couple more years, and we can all find out how badly we screwed up on repair and maintenance estimates.

Of course, if you’re looking at purchasing investor-owned property, such as multi-family properties, then you can get a statement of historical operating expenses to determine what those are. Then you can get schedules from their tax returns to determine what they really are. Oh, and then you can go through the same process as noted above to determine what they really, truly will be after you buy it.

Breaking it Down–Purchase Costs

Purchase costs consist of two components–price and rehab costs. For rehab costs, you’re determining an estimate of putting the property in rent-ready condition, either by estimating costs from your own experience (that’s what we do) or by obtaining pricing materials and obtaining labor bids (that’s when we find out how wrong we were).

You may have a set minimum price for a property (oftentimes the case with HUD properties, estate sales, or bank-owned properties) and calculate the capitalization rate to determine how the property compares to other opportunities. Alternatively, you might use a capitalization rate, at least to some degree, to determine how much you’re willing to pay. That is, you may determine that you are able to buy comparable investments with an 8% cap rate, so you calculate the maximum price that you’re willing to offer as

Max. Price

=

NOI 8%

-

Rehab Costs

Applied to TWA, with some fudging

For purposes of illustration, I ran the numbers on the TWA properties for a 12-month period–about mid-2006 to mid-2007. Using our prior naming conventions, here’s how it shakes out:

Property	Price	Rehab (+holding costs)	NOI-Actual	Cap Rate
The Ranch	$108,000	$5,000	$11,572	10.20%
No Basement	$89,000	$13,000	$9,993	9.80%
The Problem Child	$123,800	$14,000	$12,760	9.26%

Beyond the cap rates suggesting that The Ranch is the best of the three properties, we might determine from these calculations that future investments should be in the range (or higher) than our existing properties since we know that these rates are achievable.

However, a couple of important notes here. First, we are using actual NOI for the 12-month period except that I have applied a 5% vacancy factor. Our vacancy rate on the three properties was zero for this period, but a reasonable vacancy allowance is important for purposes of projections. While any assumption, consistently applied, wouldn’t change how cap rates compare, using the same vacancy rate for different types of properties (again, multi-family versus single-family for example) probably diminishes the accuracy of the comparisons.

Second (and this is some of the fudging part), I’ve used historical data for one year for purposes of illustration. Why this particular 12-months? Actually, the reasoning is pretty simple. We finished the rehab for The Problem Child near the beginning of that 12-month period, and I wanted to work in three example calculations. (The Loft is conspicuously absent because we’ve owned it for less than a year). However, by picking a sort-of random 12-month period, I only captured actual costs, like maintenance and repairs, for that period. For example, I noticed for that period that maintenance and repair costs were extremely low, which in part suggests the higher cap rate. A longer period would be more reflective of true maintenance and repair costs, which is what you’re going to try to capture in your projections for purposes of evaluating potential investments.

Conclusion–Good Investments or Bad Investments?

I would suggest we don’t have enough information from capitalization rates to determine whether a property, in the abstract, is a good investment or bad investment. Rather, capitalization rates are probably better at determining, between properties, which is gooder. Well, you know what I mean.

In some upcoming articles, we’ll be looking at some measurements of returns that start to address the good investment/bad investment question. In the meantime, feel free to leave a comment on criteria that you use to evaluate real estate investments.

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Tagged as: capitalization rate, real estate investing, returns