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Calculating the Cap Rate

Calculating the Cap Rate

In evaluating investment opportunities, desired rate of return drives value.

Income capitalization is a method to evaluate an investment by estimating the investment's future income stream, then taking into consideration the time value of money. It's also called discounted cash flow analysis.

The broad notion is to project the future income stream, then discount those future incomes for each year to a net present value, then total the net present values for all years in the planning horizon. Think of the discounting process as the reverse of earning interest.

Investors can use the approach to value investments that are expected to generate income forever, such as land, or for a finite term, such as oil wells.

In the case of land, which is expected to generate earnings forever, the complex string of discounting calculations can collapse down to expected annual earnings divided by the discount rate. For example, suppose you expect land to earn $100 an acre. You want a 10% return on your investment. Dividing $100 by .10 gives $1,000 an acre that the land is worth.

To check your calculations, multiplying $1,000 times .1 gives $100. If you buy the land for $1,000, earning $100 a year would give you a 10% return.

What rate of return do you want?

The key question in setting the income capitalization rate is, "What rate of return do you want to get on your investment?" One factor is opportunity cost on your capital—rate of return you could get on your money invested elsewhere. Another factor is risk you perceive in the alternative investment relative to risk you see in land.

Another guidepost is interest rate you'd pay to borrow money to invest.

Rampant uncertainty during the world credit crisis made return of principal more important to some investors than return on principal. Short-term interest rates collapsed near zero. Ten-year bond rates fell to 3%. Washington pressured interest rates lower to help stimulate the economy out of the great recession.

With the national debt mounting, the economy recovering and inflation likely to accelerate, assuming Washington will try to keep interest rates low forever is, at best, heroic.

A lot more upside exists in interest rates than downside. That means some alternative investments have more upside. Upward pressure on interest rates and income capitalization rates puts downward pressure on land values.

Do not expect interest rates to stay at current levels forever.

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