When purchasing real estate for personal use, such as your home, you select the neighborhood you want to live in, determine your budget, and begin looking at houses in your price range, perhaps with the assistance of a realtor. Major factors impacting prices within a given neighborhood include the square footage of the home, its age, the quality of the construction and finishes and amenities (i.e., number of bathrooms, fireplaces, outdoor space). To compare units in the same building, or similar properties in a neighborhood, the price per square foot is a good metric.
Prices for commercial properties and residential properties held for investment, however, are more commonly compared using their capitalization rate, or “cap rate.” The cap rate formula is a ratio that relates the rate of return on your investment, based on the income of the property, to the purchase price.
To find the cap rate, you can use this simple formula:
Cap Rate = Annual Net Operating Income / Market Value (Price)
The net operating income (NOI) is the net income generated by the property, usually from tenant rents, less the amount of taxes and any operating expenses, such as insurance and utilities. The purchase price used in the formula is the fair market value of the property, excluding any transaction and loan costs. So for example, a property that generates $300,000 in annual net income listed for sale for $5.5 million is being offered at a cap rate of 5.45% (300,000 / 5,500,000). If the transaction closed at this price, the investor could be receiving a 5.45% annual return on the investment.
The higher the cap rate, the greater the cash income the property is likely to generate (or, put differently, the less you will pay to acquire the asset in relation to the anticipated initial cash flow). While the price per square foot may be a consideration, cap rates are more frequently used to evaluate commercial properties because most investors are buying them for the cash flow rather than for their own business operations.
Cap rates enable investors to compare the prices of different buildings in different locations with the same tenant (i.e., a new Walgreens in cities A, B and C), or nearby properties with different tenants (i.e., Walgreens, CVS and Rite Aid). In general, a new commercial building in a dense, urban area will have a lower cap rate (i.e., be more expensive) than the identical building would have in a sparsely populated location. Other factors affecting the cap rate include the creditworthiness of the tenants, existence of a corporate guaranty (and by whom) and the length and terms of the in-place leases. Simply put, the cap rate formula can help you compare the prices of alternative, cash-flowing properties, but it is not a characteristic inherent to a property.
Note that the cap rate formula does not necessarily indicate an investor’s actual return. Cap rates only look at income and property value at a specific point in time, namely, the time of sale. The cap rate is not intended to measure performance over an extended investment period. Importantly, the cap rate does not take into account prospective changes in the operating income of the property, or in the underlying market value. In the example above, if the annual NOI were to increase to $400,000 per year, the investor’s rate of return would be 7.27% for that year ($400,000/$5,500,000). However, NOI and investor return could also decrease, whether as a result of tenant vacancies or unfavorable shifts in rental rates under new or existing leases. This is especially important to consider if your tenant’s lease is due to expire in the near future, if there is a reasonable likelihood that your tenant will require rent concessions, or if you believe the local or national economy is weakening.
Similarly, if the income stream remained constant at $300,000 but the value of the property itself rose, say to $6 million, the cap rate for a sale at that point in time would be only 5%. This is one reason why a cap rate is not relied upon to predict future returns when a property is purchased as a “value add” or “fix and flip” opportunity. The cap rate does not capture the value of potential appreciation if the property itself or the neighborhood improves.
Further, capital expenses that may be the owner’s responsibility are not taken into account in calculating the cap rate, nor are loan costs, closing costs and other transaction fees. The investor’s return may also be improved by using leverage, but mortgage debt, interest rates and loan fees are not considered in finding the cap rate. This enables an investor to compare the value of the underlying properties themselves without regard to how the acquisition will be financed.
Using the cap rate formula for evaluating investment properties does not mean that the factors typically considered for homes and other personal use are irrelevant—they are certainly important to examine closely before buying any real estate. In fact, market data such as the average price per square foot for comparable properties in the neighborhood can serve as a useful “check” on the reasonableness of your purchase price. However, an understanding of cap rates will enable you to better compare commercial acquisition opportunities when performing your investment due diligence.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Investing in Commercial Real Estate, Investing in Residential & Multi-Family Real Estate and How to Value Your Assets. This is an updated version of an article originally published on July 20, 2016.]
©All Rights Reserved. July, 2020. DailyDAC™, LLC d/b/a/ Financial Poise™
Tracy Treger is Principal at Syndicated Equities. Tracy helps high net worth individuals and family offices to profitably invest in real estate. She also assists investors in identifying appropriate replacement property to complete tax-deferred exchanges under Section 1031 of the Internal Revenue Code. Drawing upon her 20 years of legal experience in the areas of…
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