For the astute commercial real estate investor, the cap rate [AKA Capitalization Rate] is an important financial number to consider. Here’s why:
Commercial Real Estate Earns Income
One main identifier that defines commercial real estate from other types of real estate is that it earns income for its owner. Commercial real estate values are typically based on these current (and/or future) income streams from the property under evaluation.
While there are many types of commercial real estate, such as strip malls, office buildings, condo projects, industrial sites, and several other property types, each is supposed to produce net income.
Each of these commercial real estate properties will normally have an income stream and associated expenses. It doesn’t matter if it is a mall, hotel or a trailer park. All commercial real estate properties typically have both income coming in and expenses going out.
The Raw Land Exception
The one exception to this typical ‘rule of thumb’ is raw land. Raw land will many times not have any income stream, so it has to be evaluated differently for commercial purposes
Evaluating the Cap Rate
When a commercial real estate property is evaluated, the buyer does his or her best to ascertain the accurate and sustainable income stream the property is currently producing. The cap rate is based upon current financial numbers, not future. And if it is not being used to its highest and best use at the moment, an adjustment will also be made as to its income stream once any problems are corrected.
Income streams can come from a variety of places, so I won’t make any attempt to list all the various forms here. There are some common ones and some unique to a given property. Just remember that the income stream is made up of all money received through the property.
Expenses Paid Out
The other side of the cap rate equation is the expenses that must be paid on the prospective property. There can be literally scores of different expenses, which can be found in any reasonable accounting course, so we won’t go into them here.
The Cap Rate Configuration
Now that we understand that the cap rate is determined by comparing income and expenses, the final part we need to factor in is the selling price of the commercial real estate. We’ll use an example below:
– Expenses $50,000.00
= Remaining $50,000.00
Selling Price $500,000.00
Cap Rate = Remaining / Selling Price = $50,000 / $500,000 = 10%
Now you understand all the pieces of the cap rate formula and how to determine it. Again, the cap rate is very important in commercial real estate transactions because it puts a number or “grade” on the value of the deal in simple and consistent terms for the investor.
The larger the cap rate, the better the deal is for the investor, so you can draw the conclusion that investors prefer high cap rates, and the higher the cap rate is, the more the investor likes the deal.
In fact, some investors set minimum cap rates before they’re interested in a commercial real estate deal. So you understand why ‘Cap Rate is King’ in commercial real state transactions.