When you plan to purchase commercial real estate as an investment, you always analyze cap rate whether the property is a good deal. You weigh all the factors to determine if it’s truly worth investing in. As a diligent investor, you consider potential returns using different metrics before making a decision. After all, no one wants to risk money on a property that won’t yield strong returns.
One important metric in evaluating a commercial real estate investment is the Capitalization Rate. In this article, we will explain what a cap rate is, why it’s important in commercial real estate investing, how to calculate it, and how to assess whether it’s good or bad.
What is a Cap Rate?
In commercial real estate (CRE), the Capitalization Rate, or “cap rate,” is a metric used to assess the potential return on an investment. It measures the rate of return based on the property’s Net Operating Income (NOI) and is expressed as a percentage, usually between 3% and 20%.
Simply put, a rate represents the yield of a property over a one-year period, assuming the property was purchased without a loan. It gives investors a factual snapshot of the property’s expected return.
How to Calculate Cap Rate
Fortunately, calculating a cap rate is straightforward. You only need two elements:
- Net Operating Income (NOI) of the property
- Purchase Price of the property
Using these, you can apply the following formula:
Capitalization Rate = (NOI / Purchase Price) x 100
For example, you divide the property’s net operating income by its purchase price. Then, multiply by 100 to get the cap rate as a percentage.
Breaking this down, NOI represents the income minus expenses, while the purchase price is the assessed sales price. If the purchase price isn’t available, you can use the current market value or appraised value instead. Typically, rates have an inverse relationship with property value—the higher the cap rate, the lower the property value, and vice versa.
Why is Cap Rate Important?
The cap rate helps investors decide whether to pursue a commercial property. It’s also a useful baseline for comparing investment properties in a particular market.
For instance, if you compare properties in your market, one might have a cap rate of 6.75%, another 7.35%, and a third 7.50%. If the property you’re interested in has a cap rate of 7.10%, this indicates it’s fairly comparable to others in terms of expected returns and sales prices.
However, if you notice properties with lower rates, say 4-5%, this could signal a red flag. Why would the property you’re eyeing sell for such a low price compared to its potential income? Is there something wrong with the property?
Cap rate can also signal potential risk. Properties with higher cap rates tend to be in developing areas and come with higher risks. Conversely, properties with lower rates are often in stable, high-demand areas, which explains their higher purchase prices.
What is a “Good” Cap Rate?
A common question asked by those new to real estate is, “What is a good cap rate?” The answer depends on how the cap rate is used. If you’re selling a property, a lower cap rate is beneficial because it means a higher property value. On the other hand, as a buyer, you’ll likely seek properties with higher cap rates, which indicate lower initial investment costs.
That said, cap rates shouldn’t be the only factor in making a purchase decision. A good investor considers all the factors that make up a property, not just the rate.
It’s also important to remember that different cap rates represent different levels of risk. Low cap rates usually indicate lower risk, while high cap rates come with higher risk. Therefore, the “ideal” rate depends on your personal risk tolerance as an investor.
Need assistance with your 1031 Exchange or DST? We’ve got you covered!
We’ve prepared a comprehensive, free e-book designed to guide you in achieving your long-term business goals or acquiring that dream property you’ve been eyeing.
Meet The LeveragedCRE Investment Team
Phill Tomlinson and Eric Butler are seasoned commercial real estate brokers with over 44 years of combined experience. They lead the LeveragedCRE Investment Team at Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, specializing in investment sales and tenant/landlord representation across the Phoenix and Scottsdale submarkets.
The team leverages their extensive knowledge and expertise to help investors and property owners maximize their returns and navigate complex real estate transactions with confidence.
Stay informed with the latest in Commercial Real Estate strategies designed to enhance your income property investment results by bookmarking www.leveragedcre.com. Let us help you stay ahead in the market!