There are many tools used in today’s marketplace to evaluate commercial real estate investments. Most investors utilize one or two to help make a purchase or sale decision. The Cap Rate (capitalization rate) is one of the most widely used.
What Exactly Is Cap Rate?
The simple definition of Cap Rate is: the NOI (net operating income) divided by the current market value (sales price) of the property. The result is a percentage that indicates the actual Cap Rate and the potential rate of return on the real estate investment for the first year.
Capitalization Rate = Net Operating Income / Current Market Value
Here is an example:
Purchase price = $950,000
NOI = $ 95,000
Cap rate = 10%
95,000 / 950,000 = .1 (or 10%)
NOI is a before-tax calculation where operating expenses and anticipated vacancy are subtracted from gross income. Operating expenses do not include financing expenses or income tax payments. NOI is a good indicator of the financial strength of the property. There is no “best” Cap Rate; every investor has his or her own threshold and many factors must be considered.
What You Need to Consider
Using a Cap Rate to evaluate an investment is a bit more complicated that just looking at the number. Proper due diligence should be utilized to determine whether location, demographics, vacancy rates, growth and supply as well as loan-to-value and insurance rates, which all need consideration. An experienced commercial Realtor can help with all of these evaluations.
One of the disadvantages of using Cap Rate to analyze a purchase is that it only shows the value for the first year. If the market value goes up or down, or NOI increases significantly, the Cap Rate will change and therefore so will the value of the property.
In addition to utilizing Cap Rate on the initial purchase, it can be used to determine whether the property is continuing to perform at an acceptable level. For whatever reason, should the Cap Rate decline over an extended period, it may be wise to consider selling the asset. A well-performing asset will have a Cap Rate that increases at or above the property value increase.
Making the Right Investment
The most important thing to remember is to use the services of a seasoned commercial Realtor should you consider investing in commercial real estate.
*We have provided attachments with analysis of Industrial, Office and Retail property in Tampa/St Pete for the 4th Quarter of 2017.
Tampa_St Pete Industrial Report Q4 ’17
Tampa_St Pete Office Report Q4 ’17
Tampa_St Pete Retail Report Q4 ’17