Any discussion of cap rates should begin with an understanding of what it is and how it is calculated. Cap rate, or capitalization rate, is the rate at which an investment pays for itself with the income it generates. When all expenses are deducted from income, the amount left, as related to the investment, is the cap rate. In other words, if after all expenses, an investment returns $10,000 that year on an initial investment of $100,000, then it represents a cap rate of 10%. That’s $10,000 divided by the $100,000 initial investment for a result of .10, or 10%.
You’re receiving 10% of your initial investment back each year with this income and expenses. This is an important tool used by commercial real estate investors, both buyers and sellers, to determine the value of a property based on the income it generates.
How Sellers Use Cap Rates
Sellers use cap rate to set a listing price to sell their properties. Use a small 6-unit apartment project as our example. The owner wishes to sell it, so they want to determine the local market cap rates for recently sold comparable properties. They work with their selling brokerage to find some comparable recent sales. Often the cap rates are advertised in the listings. If they are not, sometimes the expenses and cash flow can be determined using other resources.
Using the sold prices and the income numbers, the actual sold cap rates are calculated and averaged across the comparable properties. For this example, assume that the average cap rate for the comparable sales is 9%. The seller knows the operating numbers for their property, in this case, the annual income minus the operating expenses is $32,000. If the seller considers their property to be roughly equivalent in condition and other factors as the comparable, then dividing it by .09 (9%), should be the listing price of the property for sale. That would be $355,556.
How Buyers Use Cap Rate
Buyers are seeking properties for investment, and they want to pay no more and preferably less than the current market value. In this example, if you’re the investor buyer, you probably have several properties under consideration. You check them all out, visit them, possibly have inspectors come in, and just generally come to some opinion as to which seem to be the best investments.
Part of that process is getting the actual operating numbers from the sellers. You will look at their profit and loss and operating financial statements to determine true expenses and cash flow. You can then calculate their cap rates. Assuming you like three properties and their relative cap rates are 9,0%, 8.4%, and 9.9%. The quickest and possibly accurate decision would be to buy the one with a 9.9% cap rate.
Just using the cap rate for the decision could be a mistake. There are other factors to look at first. What if the property with the 8.4% cap rate is charging below-market rents, though the property is in similar condition and equal in other ways? You would do a calculation to see what the cap rate would be if you raised rents to the current market level, and this could make a big difference in the cap rate to your advantage. You’d be buying at a value price. The same thing would happen if the expenses were higher than they needed to be.
On the opposite side, if the rents of the highest cap rate property were above the current market competition, and you also see that tenants are moving out after their lease expirations, you could anticipate that the rents would have to go down, so the property is possibly over-priced for the current market.
Once you’ve analyzed the facts behind the current rents and expenses, you can adjust the advertised cap rates to decide what each property is really worth to you and make an informed offer. Cap rates are important for good investment decisions, and now you are ready to make them.