There are a lot of things that determine the "value" of a given property. What has value to you may not to others. In any given market area there will be a "going" cap rate. Cap rates will differ from place to place. The hotter the market got in the past the lower the cap rates went. Now that some sanity is returning cap rates are going up. Keep in mind that cap rate reflects the relationship of the income to the price without debt. If the net operating income (NOI) ramains the same, and prices fall, cap rates go up. Rents in many areas are declining as well which also raise the cap. Use cap as a guide to the value of a property relative to the other similar properties in a given market. You must decide for yourself what factors will cause you to deviate from the "going" caps. Does the property have a great upside and therefore the return now is low compared to what it could be? Is the property priced on the future cash flows and therefore overpriced relative to what it is today? Is there something going on in the community that will cause an increase or decrease in supply or demand (Gap)? How strong is the economy of the city where the property is located? Has the property been mismanaged and do you have a plan to do it right with a resulting higher net income? Is it in an area with high crime, high vacancy, a huge inventory of cheap foreclosed homes (like Las Vegas) that will allow renters to buy? The list goes on and on. If you are using cap a your gage, figure the NOI on what it will be for you not the seller. The seller frequently has different costs than you will (they frequently understate their costs) and therefore have a different resulting cap rate. If you are looking a multiple properties and trying to decide which one is best, keep in mind cap only measures 1 year and does so without debt. If you really want to see how a property might perform you need to look at internal rate of return (IRR). IRR will measure variable cash flows over multiple years, cost of purchase and sale, and will also take into consideration debt service which cap does not. Using a gross income times a factor is a poor way to determine value. Here's an example: say the property generates 10,000 in rent gross X 10= $100,000 value. If the property has 25% expenses or $7500 net and the going cap rate is 8% the value is $93,750 and if the cap is 6% the value is $125,000. As you can see the gross times some factor is way too simple.
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Paul Sylvester, CCIM
Jun 8, 2009