Calculation of Capitalization Rate

 

Determine the Capitalization Rate

The capitalization rate is used to imply the rate of return(ROI) that is expected on an investment property. There are three methods we can use:

1. The comparison method is the most common and evaluates comparable sales in the market for the same time period to estimate the market's rate.
   
   
2. The band of investment method sums the costs of capital and desired returns to estimate the capitalization rate. Assume Mr.A  can get a mortgage for 80% of the property, leaving her to pay the remaining 20% in cash. The interest rate on the mortgage is 4%, and Mr.A wants to earn a 10% return on her cash investment.
   
   The band of investment method for capitalization rate = (80% of 4%) + (20% of 10%)
   = {(80 x 0.04) + (10 x .20)}%
   = 5.2%
   
   
3. The summation method uses the sum of the safe rate, risk rate, non-liquidity rate, and management rate to determine the capitalization rate. Safe rate is the rate of a risk-free investment such as a CD or treasury note. Risk rate is the rate of return(ROI) needed to profit on the investment. Non-liquidity rate offsets the lack of the investor's ability to gain immediate use of the investment funds. Management rate represents the costs of managing the property.
   
   

The problem with the summation method is that the capitalization rate is based on the random values selected by the investor regardless of the market norms.

An Example

So how much profit would Jill make if she renovated the complex and sold it in five years? First, the given data:

• The sales price is Rs.550,000.
• Based on comparable properties, if she invests $60,000 to renovate the units, she can earn rents of Rs.1,000 per unit per month.
• The market suggests that rents are increasing by 2.5% per year.
• Comparable properties also suggest that she can maintain a 90% occupancy.
• The operating expenses are estimated to be Rs.75,000 and are expected to stay the same.
• The capitalization rate is 7.4%.
• It is estimated that with the renovations, and an average property value increase of 3% per year,
• In five years, Jill should be able to sell the apartment complex for Rs.750,000.

We will need to calculate the following:

Net operating income for year 1 = gross operating income - operating expenses

Knowing that:

• Gross operating income = gross rental income - vacancy allowance
• rents x vacancy allowance = vacancy
• rents - vacancy = EGI (estimated gross income)
• Expenses = EGI x expense percentage
• Net operating income (NOI) = EGI - expenses

Let's work the numbers for year 1:

Gross rental income = Rs.12,000 per year per unit
Gross rental income = Rs.12,000 * 10 = Rs120,000

Vacancy allowance = 10%
Vacancy allowance = Rs.120,000 * 10% = Rs 12,000

Gross operating income = Rs.120,000 - Rs.12,000 = Rs.108,000

Operating expenses = Rs 75,000 + Rs 12,000 for the renovation over five years = Rs 87,000

Net operating income for year 1 = Rs 108,000 - Rs 87,000 = Rs 21,000

Expense percentage = total expenses / effective gross income
= Rs 87,000 / Rs 108,000
= 81%

From the year one calculations, we can estimate years 2 - 5 using the multipliers:

Year 2 rents = Rs120,000 + 2.5% = Rs 123,000

Year 3 rents = Rs 123,000 + 2.5% = Rs 126,075
Year 4 rents = Rs 126,075 + 2.5% = Rs 129,227
Year 5 rents = Rs 129,227 + 2.5% = Rs 132,458