Capital Expenditures, NOI and Income ReturnThe income return of a property investment is usually calculated as the ratio of the NOI of a property over its value. The cash flow, however, that eventually goes into the owner’s pocket, is what is left after capital expenditures are deducted from NOI. Capital expenditures refer mostly to improvements landlords need to undertake when a new tenant enters the building. The ratio of cash flow over property value is referred to as yield and represents the true income return of the property. So, the smaller the capital expenditure of a property as percent of NOI is, the higher the yield the investors earn. To understand what this has to do with property values, remember that the ratio of NOI over value represents the capitalization rate. Furthermore, consider the example of an office building and an apartment building that are bought at the same NOI/value ratio (capitalization rate). If the apartment building has lower capital expenditure as a percentage of NOI, it should provide a higher yield than the office building. Let’s see an example with numbers, taking into account that, according to the NCREIF data as of the first quarter of 2005, the average capital expenditure for apartments is 18% of NOI and for office space 34% of NOI.
As the example shows, the apartment building could be bought at a 6.4% capitalization rate and still allow the same yield as the office building. This provides a potential explanation as to why apartment capitalization rates dropped more than capitalization rates in other property types, holding values on an upward path, despite the ongoing economic downturn. Office, warehouse, and retail properties have considerably higher capital expenditures as percent of NOI, due to costly tenant improvements that landlords undertake when a new tenant enters the building.
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