Why Incremental Revenue Matters So Much
There’s nothing that frustrates a leasing agent more than a landlord who won’t budge on a rental increase – even if it’s only for 50¢. After all, in many cases that few cents is little more than a rounding error, right?
But sophisticated real estate investors and property managers understand that not only does every penny drop right to the bottom line, it also increases property value tremendously. In fact, that 50¢ can boost the value of a property by hundreds of thousands of dollars.
If that sounds like a claim from a late-night infomercial it’s not. It describes a technique used by asset managers and property managers every day to increase the value of their investment real estate.
The first step in turning 50¢ into big money is to understand capitalization rates.
What Are Capitalization Rates?
Capitalization rate – or simply ‘cap rate’ – is a term used by real estate investment professionals and managers to measure the financial performance of a property as it relates to other similar properties in the same asset class in the same market.
Cap rates are percentages that measure how much net cash a given property is generating based on the property’s net income and estimated market value. The capitalization percentage can then be used to compare the property to its competitors and determine:
- If rents are too high or too low
- If expenses are in line
- If the estimated value of the property is ‘at market’
How Cap Rates Work
To calculate a cap rate, simply divide the annual net operating income (excluding the mortgage and other non-cash expenses) by the asking price of the property:
Net Income (NOI) / Property Value = Capitalization Rate
Here’s a simple example. Let’s say we have an apartment building listed for sale at $15 million that is generating a net cash flow of $750,000 per year. The cap rate of the apartment building is:
$750,000 / $15,000,000 = .05 or 5%
To determine whether or not the apartment building is priced right we would compare it to other similar apartment buildings in the market. If competitive properties yield a 5.25% cap rate our building might be overpriced since it only yields 5%. On the other hand, if other apartment buildings have capitalization rates of 4.75% then this building might be a good deal.
What Are Other Ways to Use A Cap Rate Calculation?
The cap rate calculation can also be can also be used to calculate what the net operating income of a property should be, and what the market value of a property should be. As long as we have two of the three variables in the cap rate calculation formula, we can solve for the third.
Here are two examples:
#1. What is the market value of an apartment building with an annual NOI of $650,00 in a market where apartment capitalization rates are running 4.75%?
$650,000 NOI / .0475 cap rate = $13,684,211 market value
#2. What should the NOI of an apartment building be that has an asking sales price of $14.5 million in a market where apartment cap rates are 5.25%?
$14,500,000 asking price x .0525 cap rate = $761,250 net operating income
Are Capitalization Rates All the Same?
No, all capitalization rates are not the same. Cap rates can and do:
- Vary between asset classes as investment demand shifts to and from different classes
- Vary between property classes or grades within the same asset class
- Vary from one submarket to the next within a larger market area
- Vary from one city or geographic area to the next
But there is one thing that cap rates and capitalization calculations do have in common. They provide a quick and easy way for a real estate investor or property manager to determine the impact a pricing change will have on overall asset value.
Why 50¢ Means Big Money
Now let’s go back to our landlord who won’t budge on raising rents by 50¢.
The $15,000,000 apartment building in our first example has an NOI of $750,000 in a market where apartment cap rates are 5%. What would the value of the apartment building be if the rents were raised by 50¢, resulting in a 4% increase in NOI?
There are two steps to solving our answer:
- Calculate the increase in NOI: $750,000 + 4% = $780,000 new NOI
- Calculate the increase in property value: $780,000 NOI / .05 or 5% cap rate = $15,600,000 property value
By increasing rents 50¢ the value of our apartment building has increased by $600,000!
Every Penny Counts – Revenues and Expenses
You’ve probably heard the expression about something dropping straight to the bottom line. That’s exactly what’s happening here.
We’ve used a small increase in rents as an example. But anything that creates a seemingly small incremental revenue increase – or expense decrease – will generate a few cents that drops straight to the bottom line and will significantly increase the market value of a property:
- Standardizing turnover procedures helps capture lost revenues
- Automating contractor scheduling ensures work is completed quickly and efficiently
- Detailed information on individual unit inspections and renovations increases tenant satisfaction
- Paperless inspections integrated with ERP systems means increased productivity