What exactly is a cap rate, how do you calculate it, and why is it beneficial for commercial real estate investments? Let’s dive into one of the most important metrics to consider.
What Is a Cap rate?
The capitalization rate, or commonly referred to as the “CAP” rate, is a mathematical metric that is used to determine the rate of return and compare the sales price of similar real estate investments. It is most commonly used for commercial real estate property investments, such as retail, office, or industrial properties.
How To Calculate The Cap Rate
Calculating the cap rate for an investment property is fairly easy. Simply take the property’s net operating income (NOI) and divide it by the property’s purchase price (or current market value if you are selling the property). Keep in mind that the property’s net operating income is the total income it generates minus all operating expenses but before depreciation or debt service. For example, let’s say that you are interested in purchasing an available retail property that is for sale for $1 million. The property is fully occupied with tenants who pay a combined total of $120,000 in annual rent. Subtract the operating expenses (let’s hypothetically say is $50,000 per year for taxes, insurance, and property management fees). Now, the net operating income is $70,000 per year. If you divide $70,000 by $1 million it is 0.07, multiplied by 100, makes the cap rate 7.0%.
What Is a Good Cap Rate?
After you take the time to do the calculation above, you may be wondering if 7.0% is good - or worthy of your investment. This is where it gets a little tricky. There are many factors to consider when it comes to “good” or “bad” cap rates; such as the property type, tenancy, geographical location, current condition of the property or other factors. According to CBRE’s North America Cap Rate Survey, you can see quite a large range in cap rates in their 2019 data, as rates range from 5.1% for Multi-family properties to 8.55% for Hotels.
Why Investors Should Consider Cap Rates
Understanding the cap rate provides useful information to investors, as it can help you determine the returns and expected performance of your rental investments. If you are comparing multiple properties, calculating the cap rate can help you decide which property will be the best investment. On the other hand, when you’re ready to sell a property, understanding the cap rate can help you determine a fair market value.
While there are many factors to consider, understanding cap rates will help you to better evaluate potential investment properties, assess your property’s performance over time, and assist you with determining the market value for your property. This knowledge will help you make the commercial real estate investment decision to suit your needs.