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INSIDE
M any property management
companies advertise state-
ments such as, “We treat
the properties we manage
as if they were our own.”
For this statement to be true, proper-
ty managers must constantly focus
on maintaining and increasing the
value of the real estate asset they’re
responsible for overseeing. For a
property manager to be most effec-
tive, and to truly treat the properties
as if they were her own, she needs
to have a fundamental understand-
ing of three key real estate financial
concepts: cap rate, return on cost
and leverage.
The first and most fundamental
concept is the capitalization rate, com-
monly referred to
as cap rate. The cap
rate represents the
annual percentage
return, or yield, an
investor will receive
if the property were
purchased all cash.
It is defined as the
ratio of net oper-
ating income to
property value. For
example, if Prop-
erty X was recently
built, is producing
a stabilized NOI of
$500,000, and an
investor pays $8.4 million to purchase
it, then the cap rate would be $500,000
divided by $8.4 million, or 5.95 percent.
The cap rate is a reflection of the
risk inherent in acquiring that par-
ticular property – more risk means a
higher cap rate. Cap rates vary based
on property level risk factors such as
the age, occupancy, functionality, loca-
tion, creditworthiness of the tenants,
diversity of the rent roll and length of
tenant leases.
For example, if a property is older
and has a number of deferred mainte-
nance items, an investor will require
a higher return on his investment.
Assume that PropertyY is 20 years
old, has a number of tenants who are
struggling financially, and has a sig-
nificant amount of tenant rollover in
the next 24 months. There is more risk
in this investment, and therefore the
cap rate will need to take these fac-
tors into account. If an investor, after
taking into consideration all the risk
factors, decides she will require an 8
percent yield, the purchase price can
be calculated as the NOI of $500,000
divided by 8 percent, which is $6.25
million.
The difference in cap rates between
these two examples reflects the dif-
ferent risk premiums associated with
each investment. The property with
less risk sold for a 5.95 percent cap
rate, and the property with more risk
sold for an 8 percent cap rate. It is
important to note that cap rates also
vary based on market-level risk factors
Linda Kaboth
Vice president,
director of business
development,
Rise Commercial
Property Services,
Englewood
All property managers should be comfortable calculating and using cap rates, returns on cost and leverage equations.