Journal of Property Management

INVESTMENT INSIGHTS

RATES OF RETURN REFRESHER By Eric B. Storey, CCIM, CPM

MEASURING FINANCIAL PERFORMANCE BY CALCULATING RATES OF RETURN, AKIN TO KEEPING SCORE AT A SPORTS EVENT, IS ONE OF THE SKILLS REGULARLY USED BY REAL ESTATE MANAGERS. Keep it sharp so you can continue to meet or exceed financial goals and objectives set for the properties you manage.

All measures of return for real estate investments can be classified into two separate categories: 1) income rates or 2) discount rates.

I / V = R (WHERE I = NOI, V = VALUE, R = RATE)

Once a capitalization rate has been determined, it can be applied to a specific property by estimating its annual stabilized NOI and then dividing the estimated NOI by the appropriate capitalization rate. The formula is:

I / R = V (WHERE I= NOI, R = RATE, V = VALUE)
INCOME RATES

Income rates are the ratio between one year’s income and
a specific value. This ratio can reflect performance on an
entire property or any of the individual components or
positions in a property, such as debt/equity, land/building
and leased fee/leasehold. The most common income rate
used in our real estate industry is the overall income capi-
talization rate. Capitalization is the process of converting
income into value. In the real estate world, a capitaliza-
tion rate (Ro) is the ratio between annual stabilized NOI
and overall property value. Overall cap rates fluctuate as
properties vary in use and as those properties are traded
in markets with different economic climates. Overall capi-
talization rates are most commonly determined by market
extrapolation using the following formula:
Another popular example of an income rate is known as
return on equity (ROE), also known as equity dividend
(Re) and the cash on cash rate of return ($/$). ROE is
the ratio between one year’s net cash flow and the cur-
rent equity position in a property. The basic formula for
ROE is:

I / E = ROE (WHERE I = INCOME, E = EQUITY,
ROE = RETURN ON EQUITY)

This formula has been further modified by what is referred to as the DuPont model, which accounts for the three basic components that determine ROE: net profit margin, asset turnover and leverage.

The formula used to determine these three components can be further broken down as illustrated on the next page.

CAP RATES & THE NBA What do lower cap rates and NBA franchises have in common? Overall income capitalization rates are measurably lower in cities that host NBA franchises, and even lower in population regions that host two NBA franchises, like Los Angeles and New York. Lower cap rates and NBA franchises are both typically located where the economy is strong and the future looks bright.