Examining the Importance of the Cap Rate in Commercial Real Estate

Published: 11-02-21    Category: General CRE

Specializes in providing actionable insights into the commercial real estate space for investors, brokers, lessors, and lessees. He covers quarterly market data reports, investment strategies, how-to guides, and top-down perspectives on market movements.

A laptop on a desk illustrating real estate data

One of the biggest things that separates commercial real estate (CRE) from its residential counterpart is a focus on the numbers. Indeed, if you’re looking to make the most out of going commercial, getting a strong grasp of the fundamentals is incredibly important.

Does that mean that you can’t find commercial real estate deals without knowing all of the different numbers involved? Absolutely not. But the strength of your portfolio will only grow once you learn important figures and how to structure your deals better. These are things that get better with time, so don’t beat yourself up.

What Is the Cap Rate?

Simply put, the cap (capitalization) rate is a measure that is used to look at how well a property is growing based on its income-generating potential. That sounds a little odd, so let’s break it down in greater detail.

When you’re looking at investment properties, it’s all about income. While that income can stem from various sources, let’s just call it "income" in general. To get the cap rate calculation, you take the property’s net operating income and divide it against its value.

In this case, the value of the property is its value as an asset. In other words, if you had to sell it tomorrow, what would you get for the property? It’s essential to make sure that this number is reasonable and not based on market hype.

The purpose of the cap rate is to look at the potential it has to generate money continuously, but it is different from the internal rate of return.

Evaluating Cap Rates Successfully

Ready to calculate your first cap rate? Let’s say that you have a property that you already own, and it’s doing alright. It’s time to look at how well it’s doing by the numbers. To start, let’s go with looking at the net operating income. This is going to be all of the property’s income sources after we take out all of the expenses.

So if we look at the property and find that after adding up all of the income, we have $10,000 a month, and after looking at all of the expenses, we have $3000 a month, the net operating income is $7,000 a month, and $84,000 a year. Nice! Make sure that you always use the yearly net operating income and not the monthly, or you’ll get an incorrect value for the cap rate.

Yet, we’re not done because we have to look at the current market value before we can calculate the cap rate. Some investors do use the purchase price, but we’ve found that this doesn’t lead to a very accurate cap rate.

If you review the current market value of your commercial property and find that it’s roughly $850,000, then we can just divide the yearly net operating income over the current market value.

In this case, that gives us 0.09, and when we turn that into a percentage, we get 9%.

Is a cap rate of 9% the absolute best? Not at all. However, it isn’t a bad rate and can begin to reveal where we can either increase income or lower the expenses on the property. All of these figures go hand in hand.

Other Factors That Play a Role in Cap Rates

It’s important to understand that when we begin to look at real estate by the numbers, we can easily lose track of the market as a whole. If the market only moved by numbers, it wouldn’t be as risky to be a real estate investor of any kind.

So the takeaway here is not to make cap rate the most important determining factor in purchasing a property, but to look at the "softer" factors as well.

Those factors include the location of the property, as well as the long-term growth of the area. Not every area is going to experience growth. While this is tricky to research, you can start by looking at the local newspapers and the local government’s initiatives.

Other Important Figures in CRE Deals

If you’re going to truly look at properties with a careful eye, it’s time to do some deeper analysis. You’ll be looking at a commercial real estate proforma, which will break down the different elements of the property on a quantitative level. These include looking at the cap rate and the net operating income, the expenses, the vacancy, the gross revenue, and the internal rate of return.

All of those figures are very important in real estate deals. For example, the internal rate of return shows how your investment is going by looking at the value of the money within the property as it compares to another investment. Investors often use this figure to decide whether they need to begin their exit strategy or to hold onto the property longer.

Using Cap Rates to Your Advantage

One of the best reasons to look at cap rates is when you’re considering turning to commercial real estate financing. You don’t want to jump into financing without looking at the fundamentals. When you begin to crunch the numbers, it’s very typical for the "hot deal" everyone’s talking about to quickly turn into a deal to avoid at all costs. If the income isn’t there, it can be a long way up to create the income potential.

Understanding cap rate gives you a big advantage in terms of evaluating real estate deals of any kind, including those in the commercial space. As long as you’re willing to take your time, do your research, and make sure that the numbers you put into play make sense, there’s no reason why you can’t grow your real estate investment portfolio as high as you wish.

Crunching the numbers is much easier when you put spreadsheets into play. You can even learn the basics and hire someone that analyzes real estate deals for you. If you go that route, it’s still important to know how to do it so that you aren’t setting yourself up for disaster.

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