## Why does quadrupling the tax payment diminish the value of the building by nearly half?

Properties that produce income (rents) are typically valued based on that income stream because that is what makes people want to buy them. If you cut the income in half, you cut the value of the building in half.

Net Operating Income (NOI) is the total revenue of a property less the operating expenses (which include property taxes) and capital reserves (set-asides for larger expenditures). In order to compute a value for the property, a capitalization rate ("cap rate") is used. A cap rate represents how much the market is willing to pay for a given income stream. It varies over time and for different locations and property types (office, hotel, residential, industrial, etc.).

Here's a simplified example:

Imagine 5 apartment buildings in New Haven have sold in the last year. In each case the buyer paid 8 times the NOI.

NOI Sale Price

Building 1 $100,000 $800,000

Building 2 $300,000 $2,400,000

Building 3 $250,000 $2,000,000

Building 4 $500,000 $4,000,000

Building 5 $150,000 $1,200,000

To compute the cap rate, you divide the NOI by the sale price and get 1/8, though it is typically shown as a percentage – 12.5% in this case.

NOI $100,000

____________ = Cap Rate ________________ = 12.5%

Sale price $800,000

If the buyer paid 20 times the NOI in each case, the cap rate would be 1/20, or 5%.

Cap rates tend to be in the range of 5% - 15%. A lower cap rate indicates a hot market, where people are willing to pay more for a given income stream. A buyer may think it’s worth it to pay more because they think they can increase the NOI by reducing expenses or raising rents. Cap rates tend to be higher in markets with greater risks.

If you know the NOI of a building, you can determine its value by dividing the NOI by the prevailing cap rate.

NOI $100,000

____________ = Value (like sale price above) ________________ = $800,000

Cap Rate 12.5%

Say you have an apartment building with 10 units. The average rent is $2,000/unit, so annual revenue is $2,000 x 10 units x 12 months = $240,000.

Property taxes are $25,000 and all other operating expenses are $38,000. Capital reserves are $2,000 for a total of $65,000.

That means NOI is $240,000 - $65,000 = $175,000

NOI $175,000

____________ = Value ________________ = $1,400,000

Cap Rate 12.5%

If the property taxes were quadrupled to $100,000, NOI would drop to $100,000 and the value of the building would be:

$100,000

________________ = $800,000

12.5%

If the cap rate were 5%, the value would be $3,500,000 with the projected tax payment and $2,000,000. Regardless of what cap rate you use, the value of the building is cut nearly in half by the quadrupled tax payment.

Net Operating Income (NOI) is the total revenue of a property less the operating expenses (which include property taxes) and capital reserves (set-asides for larger expenditures). In order to compute a value for the property, a capitalization rate ("cap rate") is used. A cap rate represents how much the market is willing to pay for a given income stream. It varies over time and for different locations and property types (office, hotel, residential, industrial, etc.).

Here's a simplified example:

Imagine 5 apartment buildings in New Haven have sold in the last year. In each case the buyer paid 8 times the NOI.

NOI Sale Price

Building 1 $100,000 $800,000

Building 2 $300,000 $2,400,000

Building 3 $250,000 $2,000,000

Building 4 $500,000 $4,000,000

Building 5 $150,000 $1,200,000

To compute the cap rate, you divide the NOI by the sale price and get 1/8, though it is typically shown as a percentage – 12.5% in this case.

NOI $100,000

____________ = Cap Rate ________________ = 12.5%

Sale price $800,000

If the buyer paid 20 times the NOI in each case, the cap rate would be 1/20, or 5%.

Cap rates tend to be in the range of 5% - 15%. A lower cap rate indicates a hot market, where people are willing to pay more for a given income stream. A buyer may think it’s worth it to pay more because they think they can increase the NOI by reducing expenses or raising rents. Cap rates tend to be higher in markets with greater risks.

If you know the NOI of a building, you can determine its value by dividing the NOI by the prevailing cap rate.

NOI $100,000

____________ = Value (like sale price above) ________________ = $800,000

Cap Rate 12.5%

Say you have an apartment building with 10 units. The average rent is $2,000/unit, so annual revenue is $2,000 x 10 units x 12 months = $240,000.

Property taxes are $25,000 and all other operating expenses are $38,000. Capital reserves are $2,000 for a total of $65,000.

That means NOI is $240,000 - $65,000 = $175,000

NOI $175,000

____________ = Value ________________ = $1,400,000

Cap Rate 12.5%

If the property taxes were quadrupled to $100,000, NOI would drop to $100,000 and the value of the building would be:

$100,000

________________ = $800,000

12.5%

If the cap rate were 5%, the value would be $3,500,000 with the projected tax payment and $2,000,000. Regardless of what cap rate you use, the value of the building is cut nearly in half by the quadrupled tax payment.