Posted by Jace Stolfo on Wednesday, May 27th, 2009 at 5:37pm.
The most commonly used approach when valuing Idaho income properties is the capitalization approach. Most residential sales use the sales comparison approach by finding sold "comps". The capitalization approach on the other hand looks at the potential annual net operating income and market "cap rates" to determine value. Below is an overview of how this process works.
There's three parts to the formula: Income, Rate, and Value. I remember this by thinking "IRV" and having memorized this formula:
Income / Rate = Value
Step 1: Determine Income (Annual Net Operating Income: "NOI").
To determine a property's annual NOI, you'll take gross rents less expenses.
Here's an overview of how this looks:
A) Gross Operating Income:
- Less Vacancy and Credit Loss (5%+/-).
= Effective Income
B) Annual Operating Expenses:
- Insurance - Maintenance & Repair - Property Taxes - Property Management - Utilities - Advertising
Please note: You do not include income taxes, only expenses related to the Idaho property.
Net Operating Income (NOI) = Effective Income - Annual Operating Expenses.
This sounds simple until you begin to distinguish actual income verses potential. While the value is based on potential, you'll have to verify that the advertised numbers are not inflated and compare to the historical performance of the property or similar properties.
Step: 2 Rate (Capitalization Rate)
The capitalization rate is represented by a percentage (generally 5% to 10%) and is determined by the market. For example, if a property sold for $500,000 and had annual NOI of $50,000 the cap rate would be 10% (sales price divided by the NOI). If that same sold property had an annual NOI of $25,000 the cap rate would be 5%.
The market will accept a lower cap rate on Idaho properties that have solid long-term tenants/rental history. If properties have a poor rental history the market will require a higher cap rate.
Step: 3 Determine Value
Again, here's the formula: Income / Rate = Value
Example #1: If the market cap rate on office properties is 8%. And the property you're evaluating has an annual NOI of $40,000, what's the value of the Idaho property?
Answer: $40,000/.08 = $500,000
Example #2: If you see an Idaho property for sale for $400,000 and they advertise an NOI of $30,000, what's the cap rate on the property?
Answer: $30,000/$400,000 = 7.5%.
Example #3: An Idaho property is advertised for $750,000 and you see "10% CAP RATE" advertised on the flyer. What would the NOI be?
Answer: $750,000 x .10 = $75,000.Summary: The capitalization approach is a great way to compare Idaho income properties. Keep in mind potential verses actual rental history, the strength of the tenants, and watch the deferred maintenance (roof, HVAC, etc.) Please contact me with questions on specific properties.