What is the cap rate formula for commercial real estate, and how does it work?
Understanding the cap rate formula for commercial property is paramount for real estate investors. The cap rate is a fundamental factor that comes into play when assessing the viability of purchasing a property as it provides insights into its potential return on investment. So, what exactly is the cap rate, and how is it calculated? These questions and more will be thoroughly addressed in this blog post.
The cap rate serves as a tool to evaluate the return on investment for a piece of commercial real estate. It is computed by taking the asset's net operating income (NOI) and dividing it by the original cost of the investment or its current market value.
By understanding the cap rate and its application in real estate investment, investors can make more informed decisions when considering commercial properties, whether they are located in Lancaster, PA, or any other market.
How to Determine the Cap Rate
You must first ascertain the property's net operating income (NOI) before you can compute the cap rate. The NOI is calculated by taking the property's yearly gross income and deducting all operating and maintenance costs. These costs could include rent, utilities, insurance, taxes, and property management fees.
However, keep in mind that while computing NOI, debt repayments and mortgage interest are not considered. That's because some investors employ different debt levels, while others pay cash for a property. It is simpler to compare the property type in the same market "apples to apples" if mortgage payments and interest are excluded from the NOI.
Divide the NOI by the price (or value) at which the property was purchased. You will receive the cap rate as a percentage as a result.
Let's say, for illustration, that you are looking at a commercial office building with a $1 million gross annual income. You're left with a net operating income (NOI) of $500,000 after deducting all the costs of owning and managing the property. Your calculations will be as follows if you plan to pay $8 million for this property:
Cap Rate is calculated as follows: $500k / $8m =.0625 x 100 = 6.25%
According to the investor's goals and objectives, a "good" cap rate will vary. For instance, if an investor seeks income stability, a lower cap rate with less risk can be more alluring. On the other hand, a property with a higher cap rate and more significant risk may be more attractive to an investor looking for big profits.
When choosing an investment, the cap rate is merely one of several factors. It's essential to consider additional elements like internal rate of return (IRR) and cash-on-cash return.
Cash-on-cash return against cap rate
When investing in commercial real estate, cash-on-cash return is an essential metric to consider. This computation contrasts the entire amount of capital spent with the annual pre-tax cash flow from a property, which includes interest and mortgage payments. In other words, it tells you what your annual return on investment is:
Annual Pre-Tax Cash Flow / Total Cash Invested x 100 = Cash-on-Cash Return.
Consider making a $1.6 million down payment on an office property that costs $8 million. If your annual pre-tax cash flow is $200,000 after deducting all operating costs, such as mortgage payments and interest, from your total annual income, your cash-on-cash return would be:
Cash-on-Cash Return: $200,000 divided by $1,600,000 equals 0.125 times 100, or 12.5%.
So we see, the cap rate is significantly lower than the cash-on-cash return. Both are return metrics, but they have distinct priorities. While the cash-on-cash return focuses particularly on the cash flow that an investor sees each year, the cap rate concentrates on the overall profitability of a property.
IRR versus. cap rate
Internal Rate of Return is referred to as IRR. It is a profitability metric that takes the time value of money into account. In other words, it indicates your annual rate of return on investment (ROI), taking into account the fact that cash obtained today is worth more than cash received tomorrow.
The IRR is significant because it enables impartial comparison of various investments by investors. Let's say, for illustration, that you are thinking about purchasing two separate residences. Over the following five years, both properties should produce a net income of $100,000. However, Property A will produce that income throughout the course of five years in an equal amount, whereas Property B will produce the majority of its income in Year 5.
If you only considered the anticipated return on investment, you might conclude that both investments are equally sound. Nevertheless, if you consider the time worth of money, you'll realize that Property A is a better financial decision. This is such that with Property A, you're obtaining a higher annual % return on your investment.
The End-Game
When assessing a commercial real estate investment, the cap rate is merely one of the metrics to take into account. Understanding what it is and how it's computed is crucial, but it shouldn't be applied solely in this situation. To acquire a complete view of an investment's prospective profitability, other return indicators like cash-on-cash return and IRR should also be taken into account.
Frequently asked questions
Does cap rate correspond to ROI?
There are two techniques to assess the prospective profitability of an investment property: cap rate and ROI. The relationship between the property's potential annual revenue and its sale price or value is examined via cap rate. ROI examines the connection between the sale price of the property and its prospective total return, which includes the annual income and any asset value growth.
Why is a low cap rate preferable?
Additionally, it's critical to remember that a greater cap rate doesn't necessarily indicate a superior investment. A property with a higher cap rate can be in a less desired area or have a lot of deferred maintenance, which would increase operating costs and perhaps reduce the greater return.
