Investments: NOI, Cap Rates and ROI

Two Key Factors
In a fully-valued market, an investor must pay careful attention to two crucial factors. The first is the projected growth of net operating income (NOI) during the expected period of ownership. The second is the likelihood that the capitalization rate at the time of sale will not be higher than that the going-in rate. The example below illustrates how these factors determine ultimate gain or loss.

For reference, bear in mind that in the period from 1978 to 2002, the average cap rate ("yield") for real estate, calculated by the National Council of Real Estate Investment Funds (NCREIF), was 7.9 percent, with a high of 9.9 percent in 1995 and a low of 6.3 percent in 1989.

All-Cash Investment
Assume an investor pays $1 million in cash for an apartment building with NOI of $60,000 (6 percent cap rate). Over a ten-year holding period, he anticipates rental growth of four percent annually but offsetting this is two percent annual cost for capital expenditures (CAPEX) not reflected in NOI.

At the end of ten years, annual NOI will have grown to $71,700. If he then sells the building at the same 6 percent cap rate, the price will be $1.2 million (16.67 x $71,700). This represents a total profit of $200,000, or two percent annually on the all-cash investment of $1 million. Total NOI over the 10 years (assuming the two percent increase in NOI each year) equals $657,000, or approximately 6.6 percent annually. Adding the two percent annual profit gain means an average annual return of 8.6 percent.

Upside Financial Leverage
A major benefit of real estate investing is the ability to finance the major part of the investment with borrowed funds. Assume the investor can obtain a standing (non-amortizing) loan of $700,000 at 5.5 percent interest ($38,500 annually). Then first year cash flow is $21,500 ($60,000-$38,500), or seven percent on his $300,000 cash investment.

This will grow in the 10th year (when NOI is $71,700) to $33,200, or 11 percent on the $300,000 cash investment. Over the 10 years, the total cash flow is $272,000 (NOI of $657,000 minus $385,000 total interest) or an average annual return of nine percent on his $300,000 investment.

Sale in Year 10
At the end of 10 years, the building is sold. If the cap rate has remained at 6 percent, sale proceeds will be $1.2 million (16.67 x $71,700). After repaying the $700,000 loan, the investor has $500,000, a net gain of $200,000 over the ten years, or $20,000 a year. This represents a return of seven percent annually on his $300,000 investment. Adding the average annual nine percent NOI return gives a total annual return of 16 percent.

If Cap Rates Rise
Suppose, however, the cap rate over the 10 years rose to its long-term average of 7.9 percent (i.e., a buyer will expect to receive that yield on a free and clear basis). The price then would drop to $907,000 (12.65 x $71,700). After paying the bank loan of $700,000, the investor is left with $207,000, a loss of $93,000 on his $300,000 investment. This equals a 3 percent annual loss on the $300,000 investment. Subtracting this from the annual nine percent NOI return reduces the annual return to 6 percent, a sharp decline from the 16 percent had the cap rate remained unchanged.

Beware the Cap Rate Trap
As can be seen from the above example, the benefits of real estate investing - the ability to borrow the major portion of the investment and the growth of NOI over time can produce good returns, provided the cap rate on resale is no higher than the initial cap rate.

The major profits from real estate more often come from identifying locations ready for rapid growth or by converting properties to higher and more profitable uses. Such strategies most often are carried out successfully by seasoned real estate professionals.

Continue Reading - Leases: Reviewing Annual Operating Expense Statements

Brian Bader is a Partner in the Real Estate and Hospitality Services practice in BDO Seidman's New York office. He can be reached at (212) 885-8203.

MENU TOP

Inquiries about material in the Monitor should be directed to
Alvin L. Arnold at (212) 885-8235.