Real Estate

Real-Estate Valuation

Cap rates, net operating income, and leverage — how property is priced.

1. 1. Value from NOI

   easy

   An office building generates gross rental income of \500{,}000$peryearwithoperatingexpensesof$$200{,}000$.Comparablepropertiestradeata$6%$ cap rate. Estimate the building's value.

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   NOI = 500{,}000 - 200{,}000 = \300{,}000$.

   \text{Value} = \dfrac{NOI}{\text{Cap rate}} = \dfrac{300{,}000}{0.06} = \5{,}000{,}000$.

2. 2. Implied cap rate

   medium

   An investor pays \4{,}000{,}000$forapropertywith$NOI$of$$260{,}000$.Whatisthecaprate,andhowdoesitcomparetoamarketcaprateof$6%$?

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   $\text{Cap rate}=\frac{260,000}{4,000,000}=6.5\%$.

   The purchase cap rate ($6.5\%$) is above the market rate ($6\%$), meaning the investor paid less than the market would imply for that income — a higher cap rate means a lower price per dollar of $NOI$.

3. 3. Leverage and cash-on-cash

   hard

   A property costs \5{,}000{,}000$with$NOI = $300{,}000$.Aninvestorborrows$70%$($$3{,}500{,}000$)at$5%$interest-onlyandputsdown$$1{,}500{,}000$. Compute the unlevered yield and the cash-on-cash return on equity.

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   Unlevered yield $=\frac{NOI}{\text{Price}}=\frac{300,000}{5,000,000}=6\%$.

   Annual interest = 0.05 \times 3{,}500{,}000 = \175{,}000$.Cashflowafterdebt$= 300{,}000 - 175{,}000 = $125{,}000$.

   Cash-on-cash $=\frac{125,000}{1,500,000}=8.33\%$.

   Because the $6\%$ asset yield exceeds the $5\%$ borrowing cost, leverage lifts the equity return from $6\%$ to $8.33\%$ — positive leverage.

Go deeper

• Casebook: Canary Wharf →
• Casebook: Palm Jumeirah →