¹This is an excerpt from the book Profitable Real Estate Investing: A Value Growth Approach by Petros S. Sivitanides, Ph.D.

As is the case for any other investment, high returns in property investing can be achieved if one can sell considerably higher than the purchase price. Such a strategy will be highly profitable, since it will allow large capital gains (the difference between sales and purchase price). Simple logic suggests that selling at a price that is considerably greater than the purchase price requires that:

a) The value of the property increases considerably after its purchase
b) The property is purchased considerably below its market value, because of a rushed sale or other special circumstances

Within this context, highly profitable property investing strategies need to focus on properties that have significant prospects for value increases or a href="http://www.property-investing.org/bmv-properties.html">can be bought at a significant discount. Besides capital gains (increases in value), an additional source of profit for income-producing properties is the rental income received from the tenant. A profitable property investing strategy should pursue both of these sources of investment return.

Strong increases in property income will give double bonus to a property investor because, all else equal, values will go up considerably too. The value of a property should increase when the income it provides to its landlord goes up (all else being equal), because in the capital market, where asset prices are determined, there is a vital link between the market value of a property and the income it produces. This link is described by two formulas. Formula 1 postulates that property value is the ratio of the property’s net operating income (NOI) over a rate referred to as the market capitalization rate (often referred to as the “cap rate”). Formula 2 clarifies that NOI represents the difference between the rental income produced by the property and its operating expenses, which typically include management fees, maintenance and repairs, salaries, utilities, insurance, supplies, advertising, and property taxes.

Property Value = Net Operating Income/Market Capitalization Rate (1)

or

Property Value = Rental Income - Operating Expenses/Market Capitalization Rate (2)

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Formulas 1 and 2 represent what is called in the appraisal literature the “simple income capitalization approach” in estimating property value. Historical data provided by the National Council of Real Estate Investment Fiduciaries (NCREIF) prove the validity of this rule. NCREIF collects and processes property income and value data from the largest institutional investors in real estate in the United States. Market capitalization rates for office properties, estimated from this database using the above formula from 1979-2004, have ranged between 6.3 and 9.6%. Similarly, over the same period, market capitalization rates for retail properties have ranged between 6.2 and 8.9%.

As Formula 2 indicates, if the rental income of a property increases significantly, the value of the property will increase significantly, too (assuming that the market capitalization rate does not change). The rental income of a property is determined by two factors: the rental rate charged per square foot and building occupancy. For example, two office buildings that have the same net leasable area (NLA) and charge the same rent per square foot, but have significantly different occupancy rates will have different rental income and NOI. Therefore, increases in the rental income of a property can be triggered by increases in the rental rate charged to tenants and increases in its occupancy rate.

Based on the discussion so far, it is obvious that the concept of capitalization rate is very important in the property investing terminology. By transforming Formula 1, we see that the market capitalization rate is actually the ratio of NOI over the property value. Thus, in essence, the market capitalization rate represents the income return earned by investors active in the real estate marketplace. This is shaped by forces in the capital market and the real estate market.

In developing a property investing strategy it is important to better understand how the two components of the formula (NOI and market capitalization rate) influence value. To this aim assume that you own an apartment, which you are renting to a tenant, and receive an annual NOI of $10,000. This represents the rental payments minus the yearly operating expenses associated with holding the property. Assuming a market capitalization rate of 8%, the value of your apartment can be calculated as:

V = $10,000 /0.08 = $125,000

Now, assume that during the second year you can charge higher rent so that property NOI increases by 5%. Assuming that market capitalization rates remain the same, the value of your apartment will also increase by 5% to $131,250:

V = $10,500 / 0.08 = $131,250

Notice that if the market capitalization rate goes up, income increases may not necessarily result in property value increases. If we assume that at the same time the NOI of your apartment rises by 5%, the market capitalization rate increases to 8.5%, the value of your apartment will actually decrease slightly to $123,529:

V = $10,500 / 0.085 = $123,529

However, if we assume that at the same time the NOI of your apartment increases, the market capitalization rate decreases, the percentage increase in your apartment will be considerably greater. For example, assume that during the second year, not only does the NOI increase by 5%, but also the market capitalization rate drops from 8% to 7.5%. In such a case, the value of your property will climb to $140,000, representing a 12% increase over its original value of $125,000:

V = $10,500 / 0.075 = $140,000

The conclusion is that robust property-value increases can be triggered by strong property-income increases, especially when they are combined with decreasing capitalization rates. Therefore, in developing profitable property investing strategies, investors need to identify mechanisms, circumstances, and factors that trigger increases in property income and decreases in capitalization rates.