Determine value of property from cash flow

January 8, 2011 

A friend recently told me he could project the cash flow for his small investment property, but he did not know how to find the value of the property from the cash flow.

Here is a simple way to get an indication of a property's value based on its income.

Think of a bank savings account instead of real estate. For example, say you have $100 in a savings account that pays 2 percent interest -- or $2 a year in interest.

In this example you can see three components: 1) the amount of money in the bank, 2) the interest rate and 3) the interest payment amount. If you know any two, you can calculate the third.

In the example above, we knew the amount in the bank and the interest rate, so we calculated the interest payment by multiplying the bank balance by the interest rate ($100 X 0.02 = $2).

If you know the amount of interest money being paid and the interest rate you can figure out how much money is in the savings account by dividing the interest payment by the interest rate ($2/0.02 = $100).

Likewise, you can determine the interest rate being paid by dividing the interest payment by the money in the account ($2/$100 = .02 or 2 percent).

Real estate works the same, only with different words.

The interest payment is the cash flow or income from the property after operating costs (without considering debt). This is called Net Operating Income (NOI), or "I" in real estate shorthand.

Interest rate is called the capitalization rate, or cap rate "R."

Account balance is the value of the property, "V."

It might be easier to remember these by thinking of the name "Irv."

So, similar to the savings account example, Value is determined by dividing Income by Rate, (V = I/R). Or in technical real-estate speak, divide NOI by the Cap Rate.

Let's say a property has an NOI of $50,000 and the cap rate is 8 percent. What is its value? Divide $50,000 by .08 and you get $625,000.

In this real estate example, the cap rate is 8 percent, which is much higher than for a savings account because real estate has greater risk for the investor than a savings account. Cap rates reflect risk: The higher the risk, the higher the cap rate and the lower the price. The reverse also is true; the lower the cap rate, the lower the risk and the higher the price.

Income from a property is figured as though it has no debt because the value of a property is the same, regardless of debt. Therefore loan interest and mortgage payments are excluded. Depreciation is not included either, because the value is determined before tax.

This is really pretty easy stuff, except for one thing -- the cap rate. You can know a property's income, but what cap rate should you use? That is a tough question. Everyone in the industry struggles with this question because many factors influence cap rate.

The cap rate is the return that an investor requires from the property.

In general, the cap rate is 1 to 2 percentage points higher than the long-term lending rate. But that is only a starting point, because the cap rate takes into consideration everything that affects value.

You can get an idea of the cap rate to use for a property by looking at the cap rates for similar properties that have sold, or if these are not available to you, look at properties on the market for sale. Get the NOI for the properties from your broker, then divide the property's NOI by the asking price. A word of caution: You need to make sure the NOI is correctly calculated. If you are looking to buy an investment property, determine the cap rate for similar properties on the market to see how competitively they are priced.

It is important to remember that the above will give you an indication of value based on current income, which is only one of many factors determining value. For example, comparable sales and replacement cost are major considerations.

If you need to know the true value of a property you should get an appraisal. Sometimes, instead of an appraisal a less expensive opinion of value by a qualified broker will suffice.

Chris Stephens, CCIM, is a local associate broker specializing in commercial and investment real estate. His opinion column appears every month in the Anchorage Daily News.

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