Understanding Commercial Real Estate Cap Rates
Any seasoned real estate professional should be familiar with the term Capitalization Rate or Cap Rate for short. The cap rate is a measure of a property’s investment potential, independent of the specific buyer. Regardless of who is evaluating the property, the cap rate will remain the same, and therefore two investors can do an apples-to-apples comparison of the same property using this measure. Investors, lenders, and appraisers use current cap rates to estimate the appropriate purchase price for different types of income producing properties.
What is a market Capitalization Rate?
Market cap rates are determined by evaluating the financial data of similar properties which have recently sold in a specific market. In short, the cap rate is equivalent to the return on investment you would receive if you were to pay all cash for a property, and therefore, it is our way of making the complexities of property investment more transparent. By definition, the capitalization rate is a ratio used to estimate the value of income producing properties.
Cap Rate = Net Operating Income / Property Price
Purchase Price: $500,000
Income Per Month: $15,000
Expenses Per Year: $100,000
NOI = Annual Income – Annual Expenses or (12 x $15,000) – ($100,000) or $80,000
Cap Rate = NOI / Property Price or $80,000 / $500,000 or 16%
Types of Cap Rates
Three different cap rates per property in our Sales Comps module:
- The Estimated Going-in Cap Rate
- The 12-Month Rolling Metro Cap Rate
- The Reported Cap Rate
The Estimated Going-in Cap Rate is obtained by dividing the projected net operating income for the first full calendar year of ownership by the purchase price. Our analysis projects income and expenses for the first full calendar year of ownership of the property after the indicated sale date, and results in a projected net operating income that is then divided by the sale price to obtain an estimated going in cap rate. The projection of revenue relies largely on a rent roll that estimates based on rents, vacancies and expenses observed during several years of surveys at the property or at nearby properties.
The 12-Month Rolling Metro Cap Rate is calculated from the average of the metro’s mean cap rate from the previous four quarters and provides a benchmark rate of comparison.
The Reported Cap Rate (per sale) is reported directly by the buyer, seller or other party to the transaction, and is calculated by dividing reported net operating income by the purchase price.
Source: REIS Reports