A capitalization rate, often referred to as a “cap rate” is a formula used in the commercial real estate industry to estimate the potential return on investment for a commercial property such as a building, retail space or office space. A cap rate is determined by dividing the property’s NOI (net operating income) by the market value of the commercial property in question and then adding a multiplier to determine the percentage. The purpose of this formula is to show how much income a property may generate in relation to its current price or value. This method allows CRE professionals to weed out and find those commercial properties that better fit their model of profitability commercial real estate space. While not the be-all and end-all it’s important to understand what capitalization rate is and how to calculate it.
How Important is the Capitalization Rate?
We live in a time when fluctuations in the real estate market can easily go from one extreme to the next. This is especially true in the commercial real estate industry. In 2020, Covid placed a unique strain on the marketplace. A number of brick-and-mortar operations were shuttered in favor of remote working environments.
It’s incredible to think of the variable the pandemic presented and how something as unpredictable as it was could have such a major effect. The business of doing business radically changed as commercial property values continued to slip. It was new ground for those in the commercial real estate market and adjustments had to be made and are still being made to accommodate for that and future economic concerns.
This is why many might agree that the capitalization rate formula is every bit as important. The formula creates a specific percentage and that gives potential buyers a stronger understanding of a property’s value and even hints at potential vulnerabilities if the future of the marketplace is ever in question again.
How Does One Calculate the Capitalization Rate?
There are two factors that are overlooked when it comes to determining the capitalization rate of a property. Financing and tax-related issues are purposely omitted. The cap rate is generated by a fast and easy mathematical formula.
The net operating income of the property is divided by the property value or purchase price. This is then multiplied by 100. Let’s break down these terms and what they each involve.
- NOI or Net Operating Income is the total income that is generated by the property in question. This would include rent and fees. However, you must deduct all operating expenses from those numbers to achieve your net income. As an example, you would subtract maintenance costs, property management expenses (such as maintenance items a CAM audit can identify) as well as insurance. This results in your NOI.
- Property Value or Purchase Price is exactly what is implied. What you paid for or might pay for the property is reflected here.
- Why use the multiplier? That’s what determines the actual percentage.
Once the numbers are in place, the rate is quickly and easily determined. As an example, let’s say you purchased a commercial or business property for $600,000. You set a monthly rental or lease rate and that comes to an annual sum of $100,000. Now, subtract your estimated operating expenses. For the sake of simplicity consider an annual expense of $40,000. Therefore, your NOI is $60,000. Divide your NOI by the purchase price of $600,000 and then multiply by 100. Your capitalization rate is then 10 percent.
Which is Better? A Low or High Capitalization Rate?
The answer is not as straightforward as some might like. Is 10 percent a good cap rate? Generally speaking, the higher the number the better. However, high numbers might also reflect higher risks that helped you achieve that number. This is where one might choose to take a look behind the numbers and really see what’s there.
As an instance, a high capitalization rate might suggest that the property is in a less desirable location. This could also result in higher vacancies or tenant turnover. When turnover is hot this might also affect the overall budget for maintenance or upkeep.
What about a low cap rate? What does that imply? Typically, this means that you should expect a lower ROI or return on investment.
However, this could also suggest that the commercial property is a more stable, lower risk investment. This means you might have a building that is in a better location and that tenant turnover might not be a concern. If predictability is your tempo, then your preference might be for a lower cap rate.
With every investment, there is a flip side and that’s the case here. A high cap rate might sound favorable but it’s generally a more vulnerable asset. A low capitalization rate might not yield the ROI you desire but it very well could be the better choice for a long-term asset.
These indicators are a big part of what helps a potential buyer determine the real value of the commercial property. Keen investors also mentally calculate the potential for rising costs and possible inflationary issues that might affect expenses such as maintenance and upkeep. So, while the capitalization rate generates a specific number, that result is highly dependent on the idea that those numbers can and likely will fluctuate over time.
What Could Cause Changes in those Numbers?
Something as simple as a considerable or steep rise in the price of oil can create a butterfly effect throughout the industry. This could not only cause fluctuations in the value of your building but it would also add to your overall expenses.
As an example, high gas prices would likely reflect in a slightly larger landscaping bill. Lawn machinery typically relies on gas and the probability is that the higher cost for yard maintenance would be transferred to you, the owner. This small example would not likely have a large effect on your capitalization rate but it is one of many examples that might start to stack up if the commercial real estate industry is negatively affected by lesser economic trends.
On the other end, if the value of your property depreciates, this would likely be reflected in your yearly tax bill. Again, the cap rate does not take financing into account. Debt services, such as mortgages and other financing factors have no play here. However, property depreciation does have a small silver lining or two, even if for just a moment.
What Can Your Capitalization Rate Tell You?
While the capitalization rate might not be the most effective formula for determining the true value of your long-term commercial property investment, it does help to identify factors that you may or may not find appealing. This equation might help you seek out that “high-risk, high-reward” buy. It also can help you determine if a lower risk situation is the better choice for your investment portfolio.
When it comes to commercial real estate, investors often buy on instincts and numbers. Whether you want to “get in, get out” or you’re more likely to “get in, stay in”, the capitalization rate is there to help you find a property that will fit your specific investment criteria.
This is why investors use capitalization rates. It makes it easier to compare similar properties in the same market. The formula will help to weed out investments that might not align with an investor’s methods or wants.
No matter your opinion on the formula, I think we can all agree that capitalization rate should not be the sole factor when it comes to making a proper real estate decision. It is merely there to help investors fine tune their search field when it comes to investing in commercial real estate properties.
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