How to Determine the Cap Rate in Commercial Real Estate
If you are new to the process of buying commercial property, you’ll want to know a property’s cap rate (short for capitalization rate) before purchasing it. Simply put, this metric will let you know ahead of time the potential of a real estate investment. This article will help you understand exactly how a cap rate works, how to calculate it, and when it’s indicating a property can serve as a good investment.
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What Is a Cap Rate and How Is It Calculated?
A cap rate is the metric that is used to forecast the return on investment (ROI) from a specific property. In addition to ROI, it will also provide you some insight as to what percentage of the property’s value will be considered profit. The cap rate is one of the most important numbers that you will want to analyze before you move forward with your purchase.
To calculate the cap rate, simply take net income and divide it by the property’s purchase price. Remember, to come up with your net income, you need to consider factors like taxes, insurance, and maintenance costs. These are some of the figures that you will subtract from your gross income to help you come up with the proper net income number that is used in the cap rate formula (more on this later).
How to Calculate the Cap Rate in Commercial Real Estate
Let’s get into some of the specific steps to help you calculate a cap rate. Even though we covered the overall formula in the section above, there are some details in the calculations that are helpful to understand as you plug your numbers into the cap rate equation.
- Establish the current market value of the property. You can do this by plugging the property address into some of the online real estate sites that are out there. You can also verify the value of the property with your broker or appraiser to confirm that you have the right number.
- Calculate your total income related to the property. To come up with your net annual operating income (NOI), you need to figure out all income figures related to rent, parking, and any other income that will come with your commercial property.
- Calculate net income. We briefly mentioned this earlier because this is a big part of the cap rate calculation that is often overlooked by investors. You need to subtract operating expenses (excluding the mortgage) from your gross income, such as taxes, insurance, association fees, and more.
- Divide net income by the property value. Now that you have your two main numbers set, you can easily plug these into the main cap rate formula. You should come up with a percentage number. For example, if your purchase price is $400,000 and the net income is $20,000, you come up with a cap rate of 5%. In the next section, we will talk about what this number actually means.
What is Considered a Good Cap Rate?
There is no definitive number or range of numbers that define a good cap rate. In general, it is said that the higher the cap rate, the riskier the investment. Many experts like the cap rate to be around 4 to 5%. As we mentioned, every situation is different and this is not a conclusive cap rate that everyone can rely on.
Buyers look for a higher cap rate when purchasing and sellers look to sell at the lowest rate possible to maximize their profit on the sale.
When you are making your decision, it’s important to consider these additional factors that can influence a cap rate:
- Location: A property in an up-and-coming downtown area will have a much different cap rate than a property located in a rural area. People tend to spend more money in bigger cities with higher-paying jobs and access to entertainment.
- The surrounding market: It is important to understand the competition in your area. If you buy a property that is in high demand, you will have a low cap rate with an increased purchase price.
- The type of property: In commercial real estate, you need to consider the risks and expenses related to the type of property that you purchase. For example, rental properties require ongoing maintenance. You also need to ensure that there are no vacancies so that you are bringing in a sufficient amount of income.
- Growth Potential: Evaluating the potential for increased revenue, is the market a rising economy? If you are purchasing in a market that has plateaued you will limit your potential for increased rates. Looking at the markets leading economic indicators will help you determine the market’s potential for further growth.
The cap rate is an important metric that can guide your decision to purchase commercial real estate, but it isn’t the only factor you should consider. Certain cap rates can serve as warning signs when a property is not a good potential investment. It’s always wise to consult with a commercial real estate broker to make sure that you properly weigh all of the risks related to any piece of commercial property that you consider purchasing.