** ****How to Estimate Resale Value - Using
"Cap" Rates**

By
Frank Gallinelli - __realperson@realdata.com__

Why
do you invest in income-producing real estate? Perhaps you are looking for cash
flow. Possibly you anticipate some tax benefits. Almost certainly, you expect
to realize a capital gain, selling the property at some future time for a
profit.

Your
projection of the future worth of the property, therefore, can be a vital
element in your investment decision.

INFLATION

A
fairly simple approach to this issue is the use of an inflation rate. You
bought the property today for X dollars. You make a conservative estimate as to
the rate of inflation, apply that rate to your original cost and improvements
and come up with presumed future value.

The
use of inflation as a predictor of future value typically makes sense when the
desirability of the subject property is based on something other than its
rental income. For example, consider a single-user property such as a small
retail building on a main thoroughfare. The owner of a business operating as a
tenant in such a location is probably willing to spend more for the building
than an investor would pay. In general, rate of inflation as a predictor of
future value may be appropriate when comparable sales work well as a measure of
present value (i.e., "Commercial buildings on Main Street are selling for
$200 per square foot by next year they will be up to $225.").

CAPITALIZATION

With
most other types of income-producing real estate, what you paid for the
property is not likely to make much of an impression on a new buyer. Witness
the rapid run-up and even faster collapse of prices in the late Ô80s. The
typical investor will be interested in the income that the property can
generate now and into the future. He or she is not buying a building so much as
an income stream.

That
investor is most likely to use capitalization of income as the method of
estimating value. You have probably heard this referred to as a "Cap
Rate" method. It assumes that an investment propertyÕs value bears a
direct relation to the propertyÕs ability to throw off net income.

Mathematically,
a propertyÕs simple capitalization rate is the ratio between its net operating
income (NOI) and its present value:

Cap.
Rate = NOI/Present Value

Net
operating income is the gross scheduled income less vacancy and credit loss and
less operating expenses. Mortgage payments and depreciation are not considered
operating expenses, so the NOI is essentially the net income that you might
realize if you bought the property for all cash. If you purchase a property for
$100,000 and have a NOI of $10,000, then your simple capitalization rate is
10%.

To
use capitalization to predict value requires just a transposition of the
formula:

Present
Value = NOI/Cap. Rate

The
projected value in any given year (i.e., the "present value" in that
year) is equal to the expected NOI divided by the investor's required
capitalization rate.

To
use capitalization rate as a predictor of future value, in short, is to use
this logic: "I am buying this property with the expectation that its net
operating income will represent a return on my investment. It is reasonable to
assume that whoever buys the property from me in the future will have a similar
expectation. That new investor will probably be willing to purchase the
property at a price that allows it to yield his or her desired rate of return
(i.e., capitalization rate)."

If
you project that the property will yield a NOI of $27,000, and that a new buyer
will require a 9% rate of return (capitalization rate), then you will estimate
a resale price of $300,000.

You
must never forget that, while the algebra involved here is simple, the judgments
you need to make in order to achieve an accurate prediction of value are more
complex. Your assumptions as to future years' income and expenses have to be
realistic.

The
same is true of your estimate of a new buyerÕs required cap rate. Look at the
investment from the new buyerÕs point of view and remember that there are other
opportunities competing for his dollar. Would you buy an office building with a
projected cap rate of 9% if you could buy a bond that yields 8%? What if mutual
funds are rocking and rolling at 15% and more? To attract a buyer, your
property may need to be priced so that its cap rate is competitive. The higher
the cap rate, the lower the price. In our example above, the property with the
$27,000 NOI capitalized at 12% would be worth only $225,000.

Our
discussion here has been limited to simple capitalization rates. If you would
like to delve deeper into this topic (for example, mortgage-equity cap rates),
an appraiserÕs text on income-property valuation should be your next step.

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