There is no guarantee that the valuation estimates will come to pass and the actual performance of the property could be materially different (better or worse). Herein lies one of the risks of commercial real estate investment. However, the downside is that this approach relies on estimates and assumptions about things like average rental rates, occupancy and income/expense growth. The primary benefit of using the income capitalization approach to calculate value is that it is quick and easy and the inputs are widely available. In reality, they will likely finance at least some portion of the purchase with debt, which will boost their return even higher.īenefits And Risks To Using This Valuation Technique With these inputs, the property’s estimated value is $3.57 million ($250,000 / 7%).Īt this price, the investor could expect to earn 7% annually on a cash purchase of the property. As a result, they have determined that the target property has an estimated stabilized net operating income of $250,000 and the selected cap rate is 7%. They have reviewed the historical financial statements, created their own pro forma and documented the cap rates for recent sales of comparable properties. Suppose an investor is considering the purchase of a 50-unit multifamily property. Let's look at an example to illustrate how this works. Once the entry cap rate is decided, the property’s value can be determined by dividing NOI by the chosen cap rate. Or, conversely, if the property is deemed to have less risk than the market, the cap rate could be adjusted lower. If the property has more risk, the cap rate may be adjusted higher. Cap rates are driven by many factors, all of which are associated with the perceived risk in acquiring the property. Next, these cap rates must be compared to the target property and current market conditions to determine the appropriate value to apply. To come up with an accurate estimate, it is necessary to review the recent sales of comparable properties and to calculate their cap rate based on the NOI at the time of sale and the sales price. So, more often than not, the cap rate needs to be estimated. But, the issue with this equation when trying to decide on a purchase price is that the value is not known. The formula used to calculate it is NOI divided by property value. Income and expense projections are plugged into a financial pro forma for an estimated holding period and the resulting net operating income is the first key input in the valuation equation.īy definition, the cap rate is the rate of return that an investor could expect if they purchase the property with cash.
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