Real Estate Tip – Hedge Against Future Inflation: Understanding The Capitalization Rate

Net operating income ÷ building capital cost = capitalization rate

If you bought a building in 2007 for $450,000 that produces $36,000 in net operating income, your cap rate is 8 percent. If you think of the cap rate as an investment return, you’ll use the present value of the building rather than its original capital cost. Assuming fixed rents, if the building is now worth only $360,000, the cap rate jumps to 10 percent. If the building increased in value to $600,000 the cap rate drops to 6 percent.

Because property values declined between 2007 and 2013, we saw periods of decreasing interest rates and increasing cap rates. If high inflation is just around the corner as many predict, how can a landlord hedge against the market forces that cause cap rates to plummet?

Landlords should consider using a rent increase formula, or index, to offset the impact of market forces rather than using a fixed percentage rent increase. Selecting the ideal formula won’t be easy – the relationship between rents, cap rates, inflation, interest rates, market rent increase rates and currency valuation isn’t straightforward.

Landlords and tenants are advised to learn more about this complicated mathematical iceberg, of which cap rates are merely the tip.

Today’s real estate tip is brought to you by Rick Smith, a LEED Accredited Professional and member of Bernstein Shur’s Real Estate Practice Group and Green Building Team. Stay tuned for more useful tips for real estate professionals.

For more information on rate caps or selecting an ideal formula, contact Rick at rsmith@bernsteinshur.com or 603 623-8700 ext. 8829 or 207 774-1200.