Capitalization :Direct vs. Yield Norair Yeretsian

Direct Capitalization Rate, also referred to as overall cap rate (OCR) ,
it is the overall return from an income producing property on an all cash position.
It represents the one year view of the property.
The formula is derived from the income approach to value :

OCR = NOI / Value   :

overall cap rate equals net operating income divided by value.

example : OCR   is    10 %    =   321,600   /  3,216,000

Yield Capitalization is a more dynamic perspective of the property
and it relies on discounted cash flows looking out 5 to 10 years
( or more) into the future of the property’s performance.
This is a lot more work, and with many more assumptions
being required to be made with the associated risk(s).

example :  CFBT # s from initial investment ( year 0) to EOY 1 CFBT … to EOY5 CFBT + SPBT#

time line ( also taking into account the Time Value of Money )

…… Year 0 -)->–EOY 1—EOY2—–EOY3——-EOY4—–EOY5

(804,000) .122,610..137,323..153,802..172,258.. [192,929+1,750,000]

….CFj ……..CFj……..CFj…….CFj ……… CFj……  CFj …

Flow 0 —— 1——– 2——- 3———— 4——– 5 –

Using the HP10BII calculator , you can easily run these cash flows with
the following key stroke entries :

step 1 : make sure your calculator is set to  1  P-YR
[ press shift   1 p_yr to comfirm it]

step 2 : start entering the cash flows with the initial flow
( initial investment ) going in as a negative …
[ press 804,000 then the +/- key to set :
-804,000 enter into [ CFj ]

step 3 : enter the balance of the cash flows
enter the  number 122610 [ CFj] you should see flow 1 quickly
appears and disappear, then enter the next cash flow,
till the final cash flow : make sure you add the together the
EOY5 CFBT + SPBT and enter the total as one cash flow,
otherwise your time value of money ( time line) will be thrown off.

step 4 :  by pressing  the  IRR%/YR  key , the internal rate of return is the yield
on the invested capital in the property ( stated as an annual rate ).

Therefore the result you should get on your display is :  31.01 % .
This is the before tax yield .

If we changed the Sale Proceeds Before Tax to $ 1,000,000
with the EOY5 cash flow and re-ran the numbers the resulting
IRR%/YR would equal : 21.71%

These are both great yields, now the challenge is go out and find them !

We could continue playing a What if game with altering cash flows
over the years and different  revisionary values.

There were a number of positive assumptions embedded in the above
cash flows which may not happen. Caution is the order of the day,
your assumptions must be made clear, rate of increase year over year.
The cost of capital, the rate of inflation, the risk associated with the
asset and the location. Many many more…tenants?

Let talk about it,… twitter : EnvoyCapRealty

or just below…

nyeretsian@yahoo.com May 20, 2010

Capitalization ! Norair Yeretsian

The direct capitalization approach to estimating value is a simple
yet effective way of determining a quick value or worth of an
income producing property.

Those of us in the real estate profession know it as the formula:

V= I/R . Where the V = Value , I = NOI and R= cap rate .

R = I/V , Where the R= capitalization rate ( cap rate ).

I = V x R , Where the I = Net Operating Income (NOI).

Given :  $ 70,000 NOI /$ 700,000 Value = 10% cap rate

This 10% is known as the overall cap rate ,this rate represents the return
for an investor ( return on and return of  the investment).
It represents the return for one year and on an  all cash position .

If the investment was leveraged, then we would use another simple formula

CFBT / Equity = Equity Capitalization Rate

[ also known as ROI or ROE ]

Given the NOI from above is ……………………………… $ 70,000
then we would deduct the Annual Debt Service (P+I)     – 30,000
results in CFBT …………………………………………….. $ 40,000

and Given that the $ 30,000 supports a debt of say $ 425,000
therefore our prospective client has $ 275,000 of Equity .

Calculation :   40,000 (cfbt) /275,000 (equity) = 14.55 % ECR or ROE

Since we have come this far with these calculations we could go
a little further and determine based upon the above numbers
whether the client should or should not finance this purchase?
Determining the type of leverage, positive/negative/neutral
leads us toward the resolving the question.

By comparing the OCR to the ECR we can resolve it.

If the ECR is greater than the OCR then we would have :

Positive Leverage ,  and since 14.55  > 10.0 . We have positive leverage and
so yes the client should finance this purchase as opposed to using his own
cash to make the acquisition.

In the event the OCR was greater then the ECR , the result would be :
Negative Leverage , which would lead us to Not want to finance
the purchase rather use  your own cash

If both equal :  OCR =ECR , this is referred to as Neutral Leverage
and it does not matter either way.

However one should would about your Leveraged ratio and not
get over-leveraged and be at the mercy of the rise and fall of interest rates.

Leverage and its skillful use ( maybe luck ) is one of the secrets of great wealth accumulation .

OPM , other people’s money . Use it to your real estate advantage .

nyeretsian@yahoo.com May 6,2010