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December 30, 2009

Cap Rate - 3 Simple Uses

What is Cap Rate?
Capitalization Rate, often referred to as "Cap Rate" by investors, is the ratio of net operating income (NOI) for an asset, to the asset's cost (most often real estate is the asset in question). When looking to buy real estate, Cap Rate can be used to do quick valuations on properties, or calculate the typical return of other properties that are comparable to the one you are looking at buying. To find the cap rate you use this formula:

C (Cap Rate) =  NOI (net operating income)
                                       V (Value/Cost)

So for example, if a 2 bedroom condo you are looking at will generate about $12,000 a year in net rental income (the NOI) per year, and the sales price (sold) of the property was $300,000. We can see the cap rate would be 4%. The forumla would look something like this:

(C) 4% =     (NOI) $12,000    
                      (V) $300,000

Do this on enough properties and you can start to get a good feel for what average cap rates are in different areas around you.

Cap Rate and Finding Value
Real estate investments are valued based on all kinds of criteria. Things like location, comparable property sales prices, land value, and the replacement cost to re-build the existing structure. Using the cap rate can give a simpler valuation with less variables, this can be handy when evaluating large numbers of properties. You can use cap rate to estimate value, or purchase price in this way:

(V) $171,428 =     (NOI) $12,000    
                            (C) .07 (estimated)

So if you do your due diligence and discover the average cap rate for properties you are looking at is 7%, and the income (NOI) of a particular property is around $12,000, then you can quickly estimate the average value of a property (using your estimated cap rate) to be around $171,428. 

Cap Rate to Compare Investments
If you find properties that are cash flowing around $12,000, and similar properties have sold with a cap rate around 7%, then you know that $171K is an average price for that type of property. 

If you are finding lower cap rates, that can mean less market risk, since the property is in demand. Higher cap rates usually show more market risk, as the property is not in as much demand. Properties in higher demand, often have positive factors that are driving the price of the property up, lowering the cap rate. Of course there are many risk factors to evaluate in a property, but cap rate can give you a broad, albeit, simple overview. 

Cap Rate and Realizing Opportunity Cost
It is wise, when finding a cap rate on a property you already own, to use the current price of the property to asses the cap rate, not the initial investment. The reason is it paints a more accurate picture of how your money is being used. For example, if I bought a property for $200,000, and it rents for $12,000/year, then the cap rate is 6%. But if the property appreciates to $400,000 5 years later, and rents increase to $18,000/year, I might be tempted to base the current cap rate on my initial investment since rents went up. The cap rate would then be 9%! Sweet! But, I would be forgetting the opportunity cost of having all my money tied up in that investment- $200K additional dollars now tied up in the property due to the price going up over time. Thats $200K "dead" dollars- money that is not working for me. If I look at the cap rate adjusted for current value it comes out to a 4% cap rate, not nearly as high as the 9% I thought I was getting. This could be a sign that I need to extract that $200K, or part of it, and put it to work in other investment vehicles or more real estate. Ideally as the property's price goes up over time, you want the NOI it generates to also increase over time, to maintain the cap rate at an acceptable level. 

Filed under  //   Investing   Real Estate  

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December 30, 2009

Net Operating Income and buying Real Estate

Net Operating Income (NOI) is the net income an asset will produce. Basically, if you have a rental for example, you take the gross rent, say $15,000 a year, and minus the expenses, say, $3000 a year. You are left with $12,000, which is the NOI. It is useful to figure out when buying real estate. Often people think figuring out NOI is only used for buying rental properties, but in fact, it is also useful for buying a property you wish to live in, not only as a step for figuring out a property's value, but also to see how you can reduce risk. 

Risk 
Figuring out risk, and knowing your risk tolerance is important before buying a piece of real estate, or any investment for that matter. Knowing how much you can rent a property for is obviously one of the many ways in which you can mitigate risk. If you lose your job or cant make payments or some reason, being able to rent out a property is a viable option to avoid risk of foreclosure. So it helps to look at your expenses and figure out what rental income you need to cover all expenses. 

Value
Figuring out NOI is also a step in figuring out the estimated Value of a property. Typically NOI is calculated by taking the gross rental income of a property and subtracting expenses like repairs, property tax, maintenance etc. You are then left with the NOI.

NOI typically does not include mortgage interest or depreciation as an expense since its more accurate to not include the amount of debt used to purchase the property. Debt amounts needed to buy a property vary, and depend on many factors. Excluding debt expenses leads to more accurate representations of value. 

Basically, NOI is calculated with the simple formula:

Gross Rental Income - repairs - prop tax - maintenance - other expenses = NOI

Once you have the NOI, you can use it to calculate Value and Cap Rate, which are also very useful in the purchase process.

Filed under  //   Investing   Real Estate  

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December 8, 2009

October Oahu Real Estate Charts

Unfortunately, Honolulu Board of Realtor's stats are not showing data into the 90's like before. This is a bummer as it shows a clearer picture of the markets. 

Still holding support, and showing slight strength through the downtrend line. I would like to see how it holds up after the tax credits expire however, as that is artificial boosting of Real Estate prices, which may explain the breakout through the trend-line. 

Unless it gets enough juice to break out of the last high, we are still in a consolidation period. Probably wont do that until the next bubble picks up steam, so until then, the market may move sideways. However, if it does show strength and holds that support zone, it will mean this was a good place to get in the markets. 


Filed under  //   Real Estate  

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October 17, 2009

Oahu RE Median Price and Inventory levels

Rough Analysis:

Prices tested into near the 2005 level and found support, the trend is still down, forming a wedge. Typically a market direction will be decided soon on a move out of the wedge formation. We will have to wait and see. 

Condos are not showing as nice a pattern as the SFHs. 

Throw fundamentals into the chart patterns as you will, but for whatever reason, properties are finding buyers near the 05 median levels. 

Inventory is showing some major volatility in a short span with the large increase and then the tapering off to near 06-08 levels. Interesting to note prices finding support near 05 levels, where inventory also was near its lowest point, showing some convergence. 

   

Filed under  //   Real Estate  

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