When dealing with commercial loans and commercial properties, it is very important to understand cap rate. Cap rate is a key valuation method that can help value a property and help determine if it is potentially a good investment.
When you get right down to it, cap rate gives an indication of how quickly a particular property will pay for itself. It measures the ratio between the net operating income (NOI) and the purchase price or value of the subject property. It is most commonly used to measure a commercial property, but can be applied to residential properties as well. One reason you may not see it applied to residential properties as often as commercial is that it does not take into account market factors for the value of the property, it only take into account the income generated by the property.
The formula for calculating cap rate is NOI/Value = Cap Rate. You can work this calculation backwards to value a property by using the calculation of NOI/Cap Rate = Value.
To look at an example, we need to address the NOI, or net operating income. Simply put, NOI is the total income generated by the property minus expenses to run the property. When calculating NOI, you do not deduct the mortgage payments, and it is expressed as an annual number. So a property that generates $10k/month in income, with $4k/month in expenses would have an NOI of $72,000 ($10k – $4k x 12 months).
When evaluating properties to purchase, it is good to know your cap rate. The higher the cap rate, the better the investment generally speaking. Using the numbers above, if we have a property with an NOI of $72,000 and it is on the market for $900,000, the cap rate of this property would be 8% (72,000/900,000 = .08). If the same property were on the market for $720,000, the cap rate would be 10%. Looking at these numbers, it is pretty easy to see how a higher cap rate generally translates into a better investment.
Using cap rate to give a value estimate is a good tool that many in the commercial real estate lending arena use to quickly evaluate a deal. Using the same example as above, if we know the NOI of the property, and know the average cap rate for that type of building in that area, we can quickly arrive at a value estimate. Knowing that the NOI on a property is $72,000, and that the average cap rate for similar properties in the area is 8.5%, we can quickly estimate a property value of $847,000 (72,000/.085 = $847,000 rounded). This allows investors and lenders to quickly wrap their hands around a property’s ballpark value.
One thing to be careful of when looking at cap rates is the numbers you are getting. If your net operating income number is wrong, your cap rate and/or value are not going to be accurate. Similarly speaking, if you are using a cap rate not appropriate for the area or property type, you will not have a proper valuation on a property. Understanding what cap rate is, and how to use it is an important tool for anyone involved with commercial real estate.
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