Buying Income Properties

Buying an income property is much different than buying a house. Home buyers make a lot of personal choices about the floor plan, the neighborhood, the school district and even the color of the carpets. But if the house goes up in value over the years, that’s a bonus.

Income property, on the other hand, is supposed to provide a return on your investment. Its worth is based on the economic principle of anticipation, which states that value is created by the expectation of future benefits. In other words, how much you pay depends on how much you expect to get back. Income property pays you back in two ways. First, it produces rent. Second, it pays you back when you sell it. The value of income property can be defined as the present worth of all rights to these future benefits. Like residential property, commercial real estate offers some tax benefits as well.

There are no magic numbers or formulas for estimating the value of income property. It’s a comprehensive process. To acquire a sound real estate investment, you have to go through all the steps. Even if you plan to acquire commercial property for your own business, the same principles apply. This is because commercial real estate value is based on what you could reasonably expect to receive in the form of rent along with the future sale of the property.

History of Sales and Listings
You can learn a great deal from the sales and listing history of a property. Your real estate agent should be able to help you with this. What did the property sell for in the past? If the owner has made considerable improvements, or if the real estate market has improved, the value has probably gone up. Why is the owner selling? If he or she has not made money on the property, or if it’s in foreclosure, the owner may have paid too much. If the owner has not made significant improvements, or if the real estate market has declined, the value may have gone down.

Has the property been listed for a long time without any serious purchase offers? If so, it could be over-priced. Has the property previously been in escrow one or more times but the prospective buyers failed to qualify for a loan? This is another indication that the property may be over-priced or have defects.

Tenants and Leases
When a property is fully occupied with stable long-term tenants, you know how much income you can expect. For this reason, fully occupied properties usually have a higher value than vacant ones. Properties with vacancies raise several important questions. Why are there no tenants? Why did the previous tenants leave? Has the property been poorly managed? Were the rents too high? Is the property defective in some way? How long, how much money and how much effort will it take to find and keep new tenants? And how much rent can you expect to receive?

Another, but less common situation is a tenant with a long-term lease. This can be a good thing, unless the tenant is paying less than market rent. If so, the tenant may have a type of property right called a “leasehold interest,” which reduces the owner’s “leased fee” interest. The sum of these two interests equals the total, or “fee simple” value of the property.

Local Market Conditions and Trends
Real estate markets are rarely in balance because supply seldom equals demand. Instead, the market is either oversupplied (a buyer’s market) or undersupplied (a seller’s market). Real estate follows a cycle of boom and bust just like the stock market. Naturally, everyone would like to buy at the bottom of the market and sell at the top. Experienced investors know it’s almost impossible to predict the top or bottom of any market. It’s much easier to observe current market conditions and trends. An oversupplied market lowers real estate values and an undersupplied market raises them.

Long listing times (days on market prior to sale) and a high ratio of listings to sales indicate an oversupplied market. Short listing times and a low ratio of listings to sales indicate an undersupplied market. Your real estate agent can give you these figures, which are compiled by the local multiple listing service (MLS). Larger metropolitan areas may even publish these figures in the real estate section of the newspaper. It’s not unusual for different sectors of the same real estate market to have different supply and demand characteristics. Houses priced under $150,000 might be selling like hotcakes while office buildings may not be moving at all. Real estate value is affected by other trends as well – inflation, unemployment, interest rates, consumer confidence levels and global financial markets.

Special Markets
Some types of income properties belong to special real estate markets which transcend the local economy. For example, campgrounds, motels, golf courses and resorts may be affected by regional, national and even global trends in leisure time and disposable income. If you are considering buying a campground, for instance, you should work with a real estate agent who specializes in this type of property and can advise you about national trends.

The Neighborhood or District
The neighborhood or district probably has the single most significant influence on property value. The word “neighborhood” usually refers to residential areas, while the word “district” normally describes commercial areas, but the concept is the same. Like real estate markets, neighborhoods and districts follow distinct cycles of growth, stability, decline and revitalization. Is the district declining, or is it showing signs of improvement? Property values tend to fall when a district is deteriorating and rise when it’s recovering.

Commercial buyers should study the district where the property is located. Is it a central business district, a harbor, a hospital district, a commercial strip or a historic village? Does the district have a lot of pedestrian traffic? Is it easy to find a parking space? Adjacent and off-site uses can also affect property value. A nearby supermarket generates vehicle traffic, while a tourist attraction or park generates pedestrian traffic.

Boundaries and Easements
Lot lines should be clearly established on paper and marked on the ground. If there is any doubt you should ask to see a survey map and have a licensed surveyor locate the property corners. Locating the lot lines is important for two reasons. It allows you to calculate the exact lot size, which is essential for estimating land value. Also, it may reveal potential boundary line disputes and building encroachments which can reduce value.

Easements can also influence value. A preliminary title report will identify any recorded easements along with any special conditions attached to them. Easements, like property boundaries, should be clearly established on paper and located on the ground.

Planning and Zoning
The city or county zoning ordinance describes the type of land use allowed on the property. It also specifies the development density, the height and setback of any buildings and any off-street parking requirements. Also, the zoning ordinance will help you find out if the property can be divided or assembled with other lots to increase its value. If the zoning ordinance does not allow exactly what you want, the city council or county board of supervisors may grant a variance or use permit. If you need special permits, be sure to make your offer contingent on those permits being granted.

Some older buildings may have legally nonconforming uses that were established before the current zoning ordinance took effect. These “grandfathered” uses can add value, especially if they permit higher densities or more profitable activities than current zoning allows. The city or county general plan is even more important than the zoning ordinance because it establishes the goals and policies for community growth and development. By law, the zoning ordinance must conform to the general plan. Contact the planning or building department to obtain the exact language from both the general plan and the zoning ordinance that applies to the property and the neighborhood or district where it’s located.

Remember, zoning can change. The city or county has the legal right to “down-zone” property without compensating the owner. On the other hand, property owners can reap a windfall if their property is “up-zoned.” The general plan will help you understand community growth and development patterns and anticipate future zoning changes. Special zoning districts, called “overlay zones” can apply additional restrictions. These include historic districts, planned development overlays and the state-wide California Coastal Zone. While more restrictive zoning complicates the permit process, it tends to enhance property values.

Access and Utilities
The quality of vehicle and pedestrian access may not be that important for office buildings or residential income property. However, it’s crucial for retail stores. Some retail businesses need good pedestrian traffic. Others must have frontage on a major road with easy access and ample parking. The quantity of people or cars a business is exposed to determines the type of tenant and the amount of rent. The potential rental income, in turn, determines the value of the property.

In urban areas, most people take public utilities for granted. But in rural areas we have become accustomed to water shortages, extended power outages and even building moratoriums based on the lack of water and sewer capacity. An area or city that has an extremely limited water supply would be a consideration if you intended a water dependant business. For this reason, a car wash or laundromat in such an area would probably be a bad investment. A real estate appraisal is a document designed to reflect a properties highest and best use analysis. According to economic theory, land value is based on its highest and best use as if vacant. The value of the improvements, on the other hand, is based on how they contribute to (or detract from) the value of the land.

Going along with this theory, real estate achieves its highest value when the land and improvements are in balance. However, In the real word, land and buildings rarely form a perfect match. Some mismatched properties have great potential. Consider, for example, a commercially-zoned property with an old house on it, a remnant from the days before zoning. The house could be rented, converted to a restaurant or a law office, or demolished and replaced with a retail store.

The highest and best use depends on what is legally allowed by planning and zoning regulations, what is physically possible to construct, what is financially feasible in terms of current market conditions, and what produces the most income. The best decision might be to keep renting the building as a house, especially If there is a tight rental market and lots of vacant stores and office buildings. This is sometimes called the interim highest and best use. However, as the local economy changes, there will come a time when it makes sense to convert the house to commercial use.

Site Value
Estimating site value is an important step in evaluating income property. Economic theory assigns value to land based on its current highest and best use as if vacant and ready for development to that use. This involves looking at the property as if it had no buildings or improvements on it. Appraisers use a wide variety of techniques to estimate land value, but there are no secret formulas. All value is derived from the market place, which is made up of buyers and sellers who make decisions based on limited information and a variety of personal motivations.

The simplest way to estimate land value is to analyze comparable land sales. If there are no available sales of vacant land, land value can be estimated by subtracting the value of the buildings from comparable improved sales. There are two techniques for doing this. The allocation method is the easiest, which assigns a percentage of value to the improvements. The extraction method is more precise, which calculates the depreciated value of the buildings.

It’s important to understand that the value of land per square foot tends to decrease as parcel sizes becomes larger. Land value per square foot tends to be higher for small parcels and lower for large parcels. Therefore, it’s important to compare lots which are similar in size. When comparing parcels of dissimilar size, appraisers often use some kind of graphic or statistical analysis. Modern spreadsheet programs make this type of analysis much easier than it used to be.

The Improvements
Based on the theory of highest and best use, buildings and other improvements only have value according to how they contribute to the value of the land. An old worn-out building may detract from the value of the land because it costs money to tear it down and haul it away. At the other extreme, an over-improved building won’t add any value for all the surplus dollars that were put into it.

Buildings, like almost everything else, wear out. Some parts of a building wear out faster than other parts. A concrete foundation might last for a century or more, the roof covering might keep out the rain for twenty to forty years, while carpets might have to be replaced every five to ten years. Even with regular maintenance, buildings contribute less value as they age. This loss of value with age is called physical depreciation. There is no remedy or cure for it. Buildings, like people, have a life expectancy. Buildings don’t necessarily decrease in value at a steady rate. Good maintenance and periodic upgrades can extend the economic life of a building. Also, a building’s loss in value over time is offset somewhat by the rising cost of replacing it.

Buildings go out of style and become obsolete, regardless of how well they have been cared for. Even if the building is in good shape, the floor plan may be awkward and the fixtures outdated. Some buildings suffer from botched remodeling jobs. Other buildings are just badly designed to begin with. This loss of value due to diminished functional utility is called functional depreciation. Some functional problems can be solved by remodeling. Others cannot. Another type of functional depreciation is caused by over-improvement. Some building owners sink a lot of money into remodeling and upgrading an old building – far beyond what is typical for similar buildings in the neighborhood. While the owner may recover this investment over time, they will find it difficult to get their money back with a quick re-sale. This principal also applies to some high value homes and to trophy properties acquired for prestige rather than their return on investment.

Expert Reports
Smart buyers make their purchase offer contingent on the approval of a professional building inspection report. If the building is made out of wood, it’s standard practice for the buyer to get a pest report as well. Smart sellers order these reports in advance and make necessary repairs before putting their property on the market. Expert reports help protect the buyer from making a bad investment and help protect the seller from being sued for non-disclosure of property defects. Expert reports cover a wide range of potential problems including roofs, wells, septic systems, structural stability, handicapped access, energy efficiency, hazardous materials and zoning compliance. Some buyers order an appraisal report and make their offers contingent on the property appraising for a certain value.

Some buildings are located under aircraft flight paths, next to railroad tracks or downwind from industrial plants. The resulting noise, vibrations and odors can affect the value of these buildings. This loss of value caused by external forces is called external depreciation. An oversupplied real estate market or a depressed economy can also cause external depreciation. Hazards and contamination can also affect value. Buyers should ask for professional inspections if they suspect the presence of lead paint, asbestos, harmful chemicals, radiation or leaking underground storage tanks.

The Americans With Disabilities Act of 1990 (ADA), which became effective January 26, 1992, requires many types of commercial buildings to accommodate people who use wheelchairs, are blind or have other types of disabilities. Contact your local building department or hire an expert in the field of ADA compliance for specific requirements. A visit to the local planning and building department is an important step in investigating any type of real estate. Some local zoning ordinances require off-street parking, fire sprinklers and bracing for unreinforced masonry structures. Other communities have strict design control ordinances. In many cases, hiring a permit specialist will help you navigate the legal labyrinth and expedite the permit process.

Value-Enhancing Views and Frontages
Ocean, river and lake views can add substantial value to hotels, restaurants and high-end residential income properties. However, views don’t contribute much value to warehouses and gas stations. A premium view or location could even be a problem for some types of real estate, such as affordable housing, by causing rents to rise and creating pressure for conversion to other uses.

When evaluating a view, consider proximity, height, width, orientation, obstructability and permanence. Using orientation as an example, a view with a southern exposure might support an outdoor dining area on a restaurant, where a windy and less sunny northern exposure would not. Views that can be blocked by buildings or trees aren’t as valuable as unobstructable views. Retail stores gain value from the type of frontage and exposure they have to automobile and pedestrian traffic. The direction and timing of this traffic can be critical. Urban location experts put donut shops on the way to work and video stores on the way home.

The Cost Approach
The cost approach is a method of estimating value by combining the site value with the depreciated replacement cost of the buildings and other improvements. The cost approach can be useful for appraising properties which are unusual or complex, and when there are no comparable sales or income data. The cost approach can also help buyers decide whether to buy, build or remodel. In an oversupplied (buyer’s) market, it’s generally cheaper to buy than to build. In a undersupplied (seller’s) market, it may be cheaper to build than to buy.

The Sales Comparison Approach
The sales comparison approach is a method of estimating value by comparing the property with recent sales of similar properties. This is the most common and widely-accepted appraisal approach. The simplest sales comparison method is called rank analysis. The first step is to find and confirm the sales of similar properties and rank them in order of sale price. The next step is to look at this hierarchy of comparable sales and determine which are superior, similar and inferior to the property being appraised. This establishes a range of value. The most probable value is usually somewhere in the middle of this range. This sounds simple, but it’s the way that most buyers and sellers actually arrive at a sale price.

A fancier type of sales comparison analysis is the adjusted sales comparison approach – the most common method for appraising residential properties. This technique adjusts the comparables by adding and subtracting dollar amounts for various features to make them more like the property being appraised. These adjustments are supposed to represent market reaction. The problem with this method is it involves a lot of guessing. The only way to support these dollar adjustments is to conduct a statistical analysis using a large number of sales, and few appraisers do this. For some income properties, the sales comparison analysis uses units of comparison, such as price per apartment unit or price per square foot of rentable space.

The Income Approach

Sometimes called the income capitalization approach, is a method of estimating value based on money you expect to receive in the future. This method works best for standard income properties that are fully rented and have been producing income for some time. These are sometimes called “stabilized” income properties. The income approach may not be that reliable for owner-occupied real estate, because owners don’t pay rent. Also, the income approach may be less reliable for vacant, unique, unusual or mixed-use properties.

Vacation rentals and single family residences can produce substantial rental income. However, this income may not have any relation to the value of the real estate because buyers purchase these properties for private residential use rather than investment. Also, many rural properties have something called “excess land,” or more land than is needed to support the income-producing use. Therefore, the income approach may not be that helpful in estimating the value of these types of properties.

Commercial Sales Data
In urban areas, real estate information services research commercial real estate sales and sell this information to appraisers, investors and other real estate professionals. In non-urban areas, real estate agents have the major responsibility for collecting and entering accurate and consistent income and expense data into the local multiple listing service (MLS). Without this data it’s hard for buyers, sellers and appraisers to estimate commercial real estate value. When sellers fail to fully disclose income and expense data this can mislead buyers, cause them to overpay, and lead to business failures and loan defaults.

The best time to collect income and expense data is when a seller lists his or her property. This is when they are the most cooperative and motivated. After the sale, the buyer or seller is much less inclined to release this information. The following are some descriptions of important terms and concepts used in analyzing income property.

Reconstructed Operating Statement
A reconstructed operating statement is a simple spreadsheet that lists the anticipated first year income and expenses for commercial real estate. It is a useful tool for evaluating income property. A thorough operating statement includes such things as vacancy and collection losses, replacement reserves and management expenses. However, it does not include the owner’s income taxes and mortgage payments, which are based more on the owner’s circumstances than the real estate.

Market Rent
Market rent is the rental income that a property would most probably command in the open market. The best way to estimate market rent is to look at current rents paid for comparable space.

In rural areas and small towns, comparable rental space is rarely identical to the property being evaluated, and may need some adjustments. Landlords will normally charge more rent for properties with higher vehicle or pedestrian traffic. More off-street parking may mean higher rent, and ground floor rents are usually higher than second floor rents. Small spaces usually pay more rent per square foot than large spaces. Smart landlords often charge less than market rent for stable long-term tenants, thus avoiding a lot of expenses associated with vacancy and turnover.

Leases
A lease is a written document that transfers the rights to use and occupy real estate from the owner to a tenant for a specified period of time in exchange for rent. The period of time the lease is in effect is called the term. Many residential leases operate on a month-to month basis, but commercial leases usually have a term of one or more years. In a “gross” lease, the landlord pays all or most of the property’s operating expenses and real estate taxes. In a “net” lease, the tenant pays all the operating expenses in addition to the rent. A “triple net” lease requires the tenant to pay all utilities and operating expenses in addition to rent, including the owner’s real estate taxes.

An “index” lease calls for periodic rent adjustments based on some economic index, usually the regional Consumer Price Index. Restaurants often have “percentage” leases, where all or a portion of the rent is based on a percentage of gross sales. Tenants with a “flat” or “level payment” lease pay the same rent throughout the lease term. Tenants with “graduated” or “step-up” and “step-down” leases pay different levels of rent at certain points during the term of the lease.

Leasehold and Leased Fee Interests
It’s important to examine any leases carefully, because they may grant certain property rights to the tenant and lower the value for the owner. Tenants with long-term leases who pay below market rent may have a type of property right called a “leasehold interest,” which lowers the value of the owner’s “leased fee” interest. The tenant’s leasehold interest plus the owner’s leased fee interest equals the market value of the real estate.

Leases may also include options to buy the property, the right to sublet and the right to sell the lease to another party. These tenant rights may also reduce the owner’s leased fee portion of the property value.

Measuring Rentable Floor Area
Since most leases are based on a certain amount of rent per square foot, it’s important to measure commercial floor area correctly and consistently. Commercial floor area is measured differently than residential floor area. Residential gross living area is normally calculated by measuring the exterior dimensions of the house less non-livable areas such as garages and storage spaces. Commercial floor area normally includes the interior square footage, including interior walls. However, It does not include common areas shared with other tenants such as stairways and lobbies, or major utilities such as elevators and ventilation shafts.

In 1966, the Building Owners and Managers Association published new, upgraded standard for measuring office buildings, originally developed in 1915. For more information, contact BOMA at 202-408-2662, or visit their web site at www.boma.org.

Gross Scheduled Rents
Gross scheduled rents are the total income due under all existing leases. This may or not be the same as the asking rent for unrented space. The owner’s asking price could be too high, which could be why the space is vacant.

Other Income
Other income is any other real estate-related income apart from rent, such as parking fees.

Potential Gross Income (PGI)
Potential gross income is the total income attributable to the real estate at 100 percent occupancy, before any expenses are deducted. This should include gross scheduled rents, the estimated market rent for any unrented spaces, and any other real estate-related income.

Be careful about including asking rents for unrented spaces. These could be considerably higher than actual market rents. If this type of rental space is oversupplied in the current real estate market, it may remain vacant regardless of the rent.

Vacancy and Collection Loss
Few income properties are 100 percent rented and collect all their gross scheduled rents. Some percentage of PGI should be deducted for these losses, depending on what is typical for this type of property under current market conditions.

Effective Gross Income (EGI)
Effective gross income is what is left after an allowance has been deducted for vacancy and collection losses.

Fixed Expenses
Fixed expenses don’t vary with occupancy. They have to be paid whether or not you have tenants. Fixed expenses generally include restate taxes and building insurance. Since the 1978 passage of Proposition 13 (the Jarvis-Gann Initiative), annual real estate taxes in California are limited to one percent of the assessed value, plus a small amount to service the bonded indebtedness of local districts. When the law took effect, all properties were assessed at their 1976 value. The assessed value can trend upward at a maximum rate of two percent annually. The only things that trigger a reassessment are transfers of ownership and major new construction. When either of these occurs, the property is reassessed.

Building insurance is almost impossible to calculate without an actual estimate from an insurance agent. Generally, older buildings pay higher insurance than newer buildings. Certain occupancy types (restaurants, nightclubs, etc.) pay higher rates due to higher risks. Management is usually a fixed expense, because the fee is often tied to potential gross income, whether or not the space is rented. Management expenses should be included in the operating statement, even if the property owner is the manager.

Variable Expenses
Variable expenses normally change with the level of occupancy. These include utilities, repair and maintenance, and reserves for replacement. The best indications of future utility expenses are the previous bills. But the type of building can give you some clues about future expenses. For example, older, poorly insulated buildings usually have high heating expenses. Flat roofs may tend to leak more than pitched roofs.

Repair and maintenance costs include the normal expense of keeping things in working order. Owners sometimes postpone major repair jobs, so it’s important to get a professional building inspection to reveal any deferred maintenance. Few building owners actually put money aside for repair and replacement reserves. However, this is a legitimate annual expense to consider when evaluating income property. Professional inspections can reveal the need for major work, such as roof replacements, heating and air conditioning system upgrades, and major plumbing and electrical jobs.

Leasing Costs
Leasing costs include tenant improvements and leasing commissions. These are normally associated with large commercial properties where the owner makes substantial improvements for new tenants and pays commissions to agents for negotiating and securing leases. The owner usually compensates for these costs by charging higher rents over the term of the lease. For small commercial properties, the tenant is usually responsible for making improvements and the owner does not normally use an agent to secure tenants.

Net Operating Income (NOI)
Net operating income is the anticipated first year income which remains after all operating expenses have been deducted from the effective gross income. NOI should not include any expenses for debt service or income taxes, which are more related to the owner than the real estate.

Cash Flow
Cash flow, sometimes called “pre tax cash flow,” is the net operating income minus the debt service (mortgage payments). “After tax cash flow” is the income left over after income taxes have been paid. Properties that produce a positive cash flow are said to ”pay for themselves.” However, even properties that produce a negative cash can be good long-term investments if they appreciate in value over time.

Operating Expense Ratio (OER)
The operating expense ratio is the total operating expenses divided by the effective gross income. Experienced real estate professionals can recognize appropriate expense ratios for different types of properties. Also, national organizations such as the Institute for Real Estate Management and the Building Owners and Managers Association (BOMA) conduct nationwide studies and publish these ratios. However, the most useful numbers are derived from the local real estate market.

Net Operating Income Ratio
The net operating income ratio is the simply the complement of the operating expense ratio (100 percent minus the operating expense ratio). You can also calculate this ratio by dividing NOI by EGI.

IF YOU'VE EVER DABBLED with income-producing real estate, you’ve probably heard some jargon and buzz words like yield rates, cap rates and gross rent multipliers. What do these mean and how do people come up with these numbers?

These are rates and ratios which can be useful in evaluating income property. But, like all statistics, they can be confusing and misleading if based on faulty information or used in the wrong way. Stock market investors use similar indicators, such as the price-to-earnings or P/E ratio. Analysts can determine if a particular stock is over-valued or under-valued based on their knowledge of standard and historic P/E ratios. However, some companies use creative accounting methods to report their earnings, making the P/E ratio less meaningful. Savvy stock market investors know they need to consider a variety of things, such as growth potential and risk and the time value of money. Real estate investing is no different.

Yield Rates
A yield rate is the rate of return on capital. There are all kinds of yield rates, but the one most of us know best is the interest rate. Interest rates, like all yield rates, are usually expressed as a compound annual percentage rate. Mortgage interest is usually compounded monthly, while the interest on a standard savings account may be compounded daily. Other types of yield rates are the discount rate, the internal rate of return (IRR), the overall yield rate and the equity yield rate. In fact, there are dozens of yield rates used in analyzing commercial real estate. But they all express the same thing – some rate of return on money.

The Gross Rent Multiplier
The gross rent multiplier (GRM) can be useful in estimating value because it requires only the most basic knowledge about a sale – the sale price and the annual income. The GRM is a ratio rather than a yield rate, and is simply the sale price divided by the potential gross income (PGI). Technically speaking, PGI is the anticipated next year’s rent. However, in most cases the current or asking rent can be used.

The standard rule of thumb for gross rent multipliers is somewhere around 10. This means that the market value of an income-producing property should be roughly 10 times its gross annual income. Lower GRMs are found where buyers pay lower prices and/or expect higher rents. Higher GRMs are found where buyers pay higher prices and/or accept lower rents because they expect property values to rise. Gross rent multipliers can also be based on effective gross income (EGI), which is PGI minus vacancy and collection losses. However, it’s often difficult to find this kind of detailed information about real estate sales. It’s important that the GRM be based on consistent information for each property. You can’t mix potential and effective income and come up with a reliable multiplier.

Recent sales of similar income properties should produce similar gross rent multipliers. If the GRMs are not similar, the data may be faulty or the properties may not be truly comparable. They could be located in different neighborhoods or they could be different in age, quality, condition and functional utility. Some types of properties, such as vacation rentals and single family dwellings, produce income but don’t generate reliable GRMs. That’s because their rental income is secondary to their use as private residences. Also, these types of properties often have excess land, or more land than is needed to support the income-producing use. Mixed-use properties, such as homes with rental units, usually don’t produce reliable gross rent multipliers either.

Rent Surveys
The most reliable way to estimate income is to determine market rent, which is the most probable rent the property would bring based on an analysis of comparable rental space. This involves conducting a rent survey. Ideally, current rental and vacancy information should be available from the local Chamber of Commerce or Board of Realtors. However, in small towns and rural areas it usually isn’t.

A rent survey is a time-consuming process which involves interviewing landlords and tenants and measuring rentable square footage. Rents, vacancy rates and square footage are constantly changing, so rent surveys have to be constantly updated.

The Cap Rate
The overall income capitalization rate, or cap rate, is another useful ratio for estimating real estate value. The term cap rate is misleading, because it implies that this is some kind of yield rate, like a mortgage interest rate. The cap rate is just a plain old ratio like a gross rent multiplier, but is derived from more precise information. The cap rate is the net operating income (NOI) divided by the sale price.

Capitalization is a fancy word for the process of converting future benefits to a present value. The main benefits from income property are rent and the future sale of the real estate (called the reversion). These require time, management and some element of risk to obtain. Cap rates can be developed by analyzing the income and sale prices of comparable properties. Cap rates are generally more precise than gross rent multipliers because they are derived from net rather than gross income. Cap rates are more sensitive to such things as vacancy rates and operating expenses. Because older buildings tend to have higher operating expenses, cap rents also reflect the age, quality and condition of the improvements.

The main problem with using cap rates is the difficulty in collecting consistent detailed real estate information. Different owners report expenses in different ways. For example, an owner who also manages the property may not include management fees as an operating expense. Also, many owners don’t include reserves for replacement as a standard expense item. Putting together accurate income and expense records is a lot of work. Some buyers and sellers consider this information to be confidential. However, because it requires some effort to assemble, this information it is often incomplete, inaccurate and not fully disclosed as part of the sales transaction.

But sooner or later lenders and informed buyers are going to ask about cap rates. Being able to provide an accurate cap rate could make the difference between getting or not getting a loan, or making or losing an important real estate deal. Therefore, it’s important to extract this information whenever possible. The standard rule of thumb for cap rates is something less than .10 (10 percent). Higher cap rates are found where buyers pay less and/or expect more rent. Lower cap rates are found where buyers pay more and/or accept less rent because they expect the value to increase during the holding period.

Some companies publish standard cap rates for various types of properties in different parts of the country. However, the best information is always derived from the local real estate market.

The Relationship Between Yield Rates and Cap Rates
Yield rates and cap rates are related, even though they are two different things. A yield rate is a rate of return on capital, like an interest rate. A cap rate is just a ratio (income divided by sale price). When a buyer expects income and property values to remain unchanged during the holding period (the time the buyer expects to own the property), the cap rate is equal to the yield rate. This is called capitalization in perpetuity. When a buyer expects income and/or property values to rise, the cap rate is lower than the yield rate. In other words, the buyer will pay more for the property because they anticipate increased future income.

Discounted Cash Flow Analysis
There is another more sophisticated way to analyze income property which has become more common with the widespread use of computerized spreadsheets. This is called discounted cash flow analysis, or DCF. The process is also called yield capitalization. It’s complicated because it projects income and expenses for a number of years, ending with the sale of the property.

DCF can be useful for analyzing large, complex properties with multiple income streams. By plugging in different numbers, investors can test their assumptions and decide whether or not to buy the property and how much to pay. DCF spreadsheets are also used to analyze land subdivision and development projects. Although these spreadsheets are impressive, the results can be speculative and misleading. Discounted cash flow analysis may be more useful as an analytical tool than as a way to estimate value. Discounted cash flow analysis is different than direct capitalization – a simple process which projects only one year of stabilized income and expenses. For the vast majority of income properties, direct capitalization simulates the process used by buyers and sellers to arrive at a sale price.

Marc Gohres

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Revised April 12, 2020 9:57 AM