How to find cap rate and true valuation of a property

Now, cap rate sounds tricky, but really isn't. Capitalization is an appraisal process to covert income streams to value. In a nutshell you can understand it easier by the following example:

”If you have a building that makes you $100,000 in rental income, you adjust this gross income by the expected rate of vacancies… Then you deduct the operating expenses you get the Net Operating Income. This number is then divided by the cap rate to give an estimated valuation of the property using the income approach”

Gross Income = $100,000
Less Vacancies = $10,000
Less Operating Expenses = $40,000
Net Operating Income = $50,000
Cap Rate = 10%
Estimated Value = $50,000 / 10% = $500,000

Off the top of my head and without any other specific question in front, the only thing that occurs to me is that no matter how hot the property is, do not use a cap rate that is substantially lower than 10%. It does not matter that market rates in other investments are very low {example CDs are paying only 2%} using a substantially lower cap rate will result on inflated valuations. If you were to use a 5% rate on the example above, you will end up with a $1,000,000 valuation.

Another important thing is to perform a sensitivity analysis. Sensitivity analysis in the context of a real estate investment loan is a projection of what will happen to the cash flow produced by a property once changes in the occupancy rate and the interest rate being charged by the lender change. It helps answer the questions of:

Will there be enough money to pay the loan if the property losses tenants?
How many tenants does it have to loose before the debt service coverage is no longer enough to provide comfort to the lender?
What is the breakeven point before the property becomes a loosing proposition and the lender has to look at the owner to make up a shortage?

You can take a look at a simple sensitivity analysis by downloading the attached spreadsheet. This one in particular only has vacancy rate as a variable. This is because most loans have a fixed rate so there is no sense in accounting for that. It is possible to do a sensitivity analysis including changes in interest rate, but those are more common on business lines of credit where the rate is usually a floating rate that moves in tandem with a base market rate.

The little spreadsheet is very flexible. It has space for two loans in case that the property has both a first and second mortgage. Changing the occupancy rates in the projections allows you to play around with "what if?" cases and by trial and error you can get breakeven.

The following are some similar terms that are used to define comparable types of analysis. Essentially, what will happen to profitability or more importantly repayment if a variable or a couple of variables change:

Similar Terms:

"Stress Test"
"Proforma cash flow"
"Pro forma"
"Projections"

I almost forgot, have to give credit where it is due: make sure that you visit the site from which I obtained this information. Thank you http://www.loanuniverse.com