In the world of commercial real estate, one of the most important considerations for buying is the overall profitability potential of a specific property. Before you invest your money into a property, you need to know what to expect when it comes to the return on your money. How much can you expect, and how fast will you get it? These are essential questions that require answers. Fortunately, you have tools at your disposal for finding these answers. You can use several methods to determine key financial metrics.
One of the most popular calculations for commercial real estate investors is the capitalization rate, commonly referred to as the “cap rate.” This metric helps you determine what rate of return you can expect. It is an excellent tool for comparing the potential of similar commercial properties before you buy. When supplemented with other methods, the cap rate is a valid financial metric.
Cap Rate Basics
All real estate investors should understand capitalization rates. The cap rate on a commercial property is a simple way to calculate the rate of return (ROR) you can expect on your real estate investment property. The ROR is the net gain or net loss in the value of your property during a certain time period and is determined as a percentage of your investment’s initial cost.
You determine the cap rate by factoring in the net income expected from the property. You then divide net operation income by the property asset value to determine the cap rate percentage. This calculation is a useful comparison tool for potential real estate investments, but it has limitations. You should never use it as the only determining factor in your real estate investment purchase.
Cap Rate Calculations
Cap are calculations are not difficult as long as you have the necessary financial information on hand. You can calculate cap rates in several ways. The most commonly used method is to divide net operating income by the current property value. The rate gives you a quick snapshot of the property’s earning potential and can inform your purchase decision.
Calculating NOI
To determine the net operating income (NOI), you will subtract all of the property’s annual operating expenses from the total revenue the property generates. The NOI does not include capital expenditures and can be altered by the owner deferring or accelerating income and expenses.
The following is an example of an NOI calculation.
The property’s gross rental income is $50,000; it has an occupancy rate of 80%, and the operating expenses are $18,000. You would multiple $50,000 x 80%, which equals $40,000. You then subtract the expenses from this total. $40,000 – $18,000 = $22,000 NOI.
Cap Rate Calculation
Once you have determined the NOI, you then divide it by the property value. In this example, the property value is $500,000. When the NOI of $22,000 is divided by $500,000, you get a cap rate of .044 which you multiply by 100 to get the percentage. The cap rate on this property would be 4.4%, a modest but positive figure.
Good Cap Rates
Once you have the cap rate, you can better analyze the investment potential of the property. A good cap rate is considered by industry experts to be anything over 4%. Of course, you may find properties with much better cap rates that would give you a better return rate on your investment.
A high cap rate is not a guarantee of profitability, however. In fact, a lower cap rate means the property offers less risk than one with a high cap rate. Plus, the cap rate does not assess other financial criteria that indicate whether a property is a good investment or not. It is just one tool for comparing real estate investment opportunities.
Cap Rate Calculators
For faster figures and better accuracy, consider using a cap rate calculator. Fortunately, you can find cap rate calculatorson many real estate and financial sites that allow you to quickly plug in NOI and property value. You can figure the capitalization rate in just minutes, which is convenient when you are comparing multiple investment properties.
Cap Rate Limitations
Cap rates are helpful but do not give you the complete picture of a property investment’s potential. For instance, the following factors are weaknesses in the cap rate calculation:
- The Time Period: Cap rates use only 12 months of NOI, so they may capture a great year or a bad one instead of an average one. The percentage can then give you an inaccurate look at the rate of return.
- Assumes a Cash Purchase: The cap rate does not reflect any mortgage payments you may need to make. If you are carrying heavy financing on the property, the cap rate’s usefulness will be limited.
- Compares Stabilized Assets: The cap rate is useful only when used on comparable stabilized properties with similar occupancy rates, market rents, and expenses. It is not useful when comparing diverse properties.
- Expiring Leases: Cap rates are not as helpful for single-tenant assets because the tenants may have only a short time left on their leases. You could calculate a similar cap rate percentage for a single-tenant property with two years left on the lease and one with 20 years left.
- NOI Variations: Cap rates may suffer from varying NOI formulas. Most investors use the last 12 months of actual income and expenses on the property. Some will use the last three months or less and annualize the income to reflect a property’s most recent rate of return performance.
For these reasons, you should use the cap rate as just one indicator of the investment property’s income potential. Cap rates can be misleading.
Cap Rate Alternatives/Additions
Cap Rates are not the only helpful indicator of an investment property’s potential. You should consider other metricsbefore you buy a commercial property. These metrics include:
- Per-Unit Price: You calculate this metric by dividing the purchase price by the number of rental units in the property.
- Cash Flow: Calculate this figure by determining expected rental income and then subtracting all expenses, including taxes, mortgage payments, utilities, and insurance.
- Gross Rental Yield: You reach this figure by dividing the annual collected rent by the total property cost, which includes the purchase price, closing costs, remodeling costs, etc. Then you multiply that number by 100 to get the gross rental yield. You should look for a percentage above 7%.
- One Percent Rule: This rule states that the gross monthly income of the rental property should be at least one percent of the purchase price. If the property reaches this threshold, it should offer a positive cash flow.
- ROI: Your return on investment is determined by first calculating your annual return. You reach that figure by subtracting your expenses from the total rental income. Then you divide your annual return by your cash investment total. You should look for an ROI of above 10%.
Remember, you should look at multiple metrics before buying the property since no one method is foolproof.
Finding Investment Properties
You can search for solid investment properties in multiple ways, of course. Many potential investors turn to their local contacts in the real estate industry for tips on available properties. Local realtors, mortgage brokers, and insurance agents generally have inside information on these properties. You can also look for discounted properties by searching local tax and foreclosure information. But you will save time and trouble by turning to ProspectNow, a property listing database that offers you a more efficient and in-depth search experience.
The ProspectNow Advantage
Choosing the right investment property means conducting a careful analysis of its profitability. One popular method is the capitalization rate. A cap rate allows you to quickly compare potential investment properties to each other to determine your expected rate of return. It is an excellent first step in your financial analysis of its investment potential.
As with any real estate purchase, your success depends on finding the right property to meet your goals. You can certainly find good opportunities by using tried and true methods such as searching state and local government sites for discounted properties or depending on word-of-mouth from your industry contacts. But, you will have more success and invest less time in your search by using ProspectNow, a vast database of property listings in the US.
Since 2008, ProspectNow has been a leading resource for real estate professionals and aspiring property investors. By using our database, you receive fast and accurate information on millions of US properties. Currently, we have approximately 100 million residential and 42 million commercial real estate listings on ProspectNow. If you are considering investing in commercial property, you should visit our site to get in-depth data on property listings in your preferred geographical area. Sign up now and get a free trial. Enhance your investment journey by turning to ProspectNow.
Final Thoughts
Determining which commercial investment property is your best buy can be difficult. Tools like cap rates are meant to help you compare similar properties in a meaningful way. As such, a cap rate is a valuable tool. It can help you take advantage of profitable investment opportunities and bypass those with less profit potential.
A cap rate has its limitations, however. Before purchasing any commercial property, use several methods to determine your ROI or rate of return. Remember that the cap rate does not include major expenses such as your mortgage payment if you have one. You will get a much clearer picture of the property’s potential if you use multiple metrics.
While your gut feeling about a property should not be overlooked, you need to back up your urge to buy with all the hard and fast figures you can acquire. Then plug those figures into a cap rate calculator so you will have solid information about the property’s income potential.