Capitalization Rate

Capitalization Rate is a ratio used to estimate the value of income producing properties. Investors, lenders and appraisers use the cap rate to estimate the purchase price for different types of income producing properties. Hence, it is decided by buyers and NOT sellers. Theoretically, Cap rate is the larger return expected by buyers when investing in high risk income properties. The Cap rate may vary in different areas of a city for many reasons such as desirability of location, level of crime and general condition of an area. Few things to note about Cap Rate:

• It defines the percentage number used to determine the current value of a property based on estimated future operating income i.e.
Cap Rate = Annual Cash Flow / Value of property

• Capitalization rates are an indirect measure of how fast an investment will pay for itself in net cash flows; each year, the percentage amount of the cap rate will be repaid
i.e. Payback period = 100% / Cap Rate

• In real estate appraisal in the U.S., a stylized measure of cash flow is often used, called net operating income. It is essentially the same as net cash flow, except that debt service and income taxes are not included while a reserve for replacements is included

• One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which only compares what other similar properties have sold for based on a comparison of physical characteristics). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset

• Cap rate could be determined based on an appraisal and/or the cap rates of similar properties that have sold recently i.e. by taking another property that sold recently, determining its rental income, divide the income by the sold price to get the cap rate

Thus, if cap rate in a given property increases, the value for that particular property reduces and vice versa.

Affordability

The affordability index, although at a reasonable 40% (EMI/net monthly disposable income), has risen about 50% over the past two years, suggesting a price run-up faster than income growth. The affordability is also affected by mortgage rates, which has risen by 400bp during the same period. Lending institutions managed to limit the EMI increase to a certain extent by adjusting the loan tenure, thereby controlling the affordability as well. Currently, the domestic real estate market has an affordability levels (Property costs / Annual Income) of 4.5 to 5.0x compared to global level of 3.5x.

Profitability analysis of properties - Developers perspective

Residential properties
From an IRR (Internal Rate of return) perspective, the residential segment is the highest return earner. This is possible due to the unique way in which the payment for residential properties is structured, where the buyer pays some upfront money and the balance by way of installments, which allows the builder to block less capital in the project. IRRs for residential projects range between 30% and 35%.

Commercial projects
The return from commercial property is always lower compared with the residential project due to the following reasons.
• There is no cash inflow until the property is completely developed and in a handover stage
• No outright sale of the property occurs; the developer must contend with only lease rentals

As a result, the developer must invest far greater capital of his own before he sees any cash inflow, and due to lease rentals, his payback period increases, in turn reducing his returns from the project compared with the residential project.

Floor Space Index (FSI)

The Floor Area Ratio (FAR) or Floor Space Index (FSI) is the ratio of the total floor area of buildings on a certain location to the size of the land of that location, or the limit imposed on such a ratio i.e. Floor Area Ratio is the total building square footage (building area) divided by the site size square footage (site area).

Floor Area Ratio = (Total covered area on all floors of all buildings on a certain plot)/(Area of the plot)

Thus, an FSI of 2.0 would indicate that the total floor area of a building is two times the gross area of the plot on which it is constructed, as would be found in a multiple-story building.

India has a notoriously low FSI ( rarely above 1.6, even in CBD) which has led to shortage of quality land banks. Someone rightly said the other day "India is a land of opportunities, without any land".