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