What is My Investment Worth?
The term Cap Rate, short for capitalization rate, simply speaks about the rate of return in relation to the capital value of the asset that is generating the return. It is a simple concept but its impact on real estate and investment is significant and profound. The fundamental equation is:
I = Income
(Net cash flow after expenses)
R = Rate of Return
( a percentage expressed as a decimal)
V = Value
(The value of the cash flow as compared to other cash flow producing assets of similar risk.)
When you have any two the third can be extrapolated by simple algebra therefore:
To look at this in real life, Say that I have a rental property that generates $36,000 annually net, after all the typical expenses (insurance, maintenance, heat, hydro, taxes, vacancy management, and etc.) What is it worth? Well, if I can establish what the typical rate of return for that type of investment is I can mathematically calculate the value. I can establish typical rates of return by looking at what other similar buildings sold for and what they generate in net cash flow so as to establish the average rate of return in the market place. I can look at other investment opportunities such as mortgages, bonds and GIC’s to see what other rates of return are available to investors.
At January 2012
Royal bank prime rate 3%
One year GiCs –1%
Ten year Government Canada Bonds – 1.94-1.99%
Five year Multi/residential mortgages>85% of value 3.95%
Sale of: 133 ABC St. 5%
Sold for: $700,000.00
with net income of $35,000.00
Sale of: 8910 xyz St. 4%
Sold for $900,000.00
with net income of $36,000.00
From These comparables I decide that 4.5% would be a reasonable rate of return for this investment.
Therefore, having the two factors that is an income of $36,000.00 and a rate of return of 4.5% expressed as a decimal of 0.045 the math would be:
Based on this principle; the lower the rate of return (percentage) the higher the value. The reason is that the higher the perceived risk, the higher the return that will be demanded. Hence the lower the value of the asset or the value of the cash flow stream that is derived from it.
There it is. This is a simple but powerful tool for analyzing any type of income generating investment.