The cap rate is very important when you are looking to understand commercial real estate. In simple terms, this is the ratio of net operating income to the property asset number and value. It’s an important metric that gives insight into the return and risk.
Here is a simple formula you can use for this calculation.
NOI/Current Property Value= Capitalization Rate x 100.
Here is an example. The property generates an income of $500,000 after the expenses are paid. The current value of the property is $5 million. The cap rate works out to 10%. In other words, it will take an investor a decade to recover an initial investment.
Why The Cap Rate Matters
It is important to understand what the cap rate indicates to a potential buyer. Potential investors look at both the cap rate and or the return on the investment. Using this metric creates a benchmark they can use to compare other commercial properties they might want to purchase.
For example, an investor who is looking at a particular sector like multi-residential properties will be able to compare one apartment building with another using the cap rate.
Trying to decide on a good cap rate for commercial real estate investment isn’t easy. These numbers evaluate different markets and compare them. They lose at least some of their efficiency when used for isolated evaluations.
Still, in the long run, this metric can help any potential investor understand if the sale price is in alignment with their investment strategy.
There are several factors that can influence this number.
Like the rate and length of existing leases. Properties that have short-term leases don’t generate as much income as those that are set for longer periods. As well, tenants that have lower credit scores are usually at a higher risk of default.
