As a real estate investor, the cap rate in commercial real estate can help you assess the property’s potential return on investment. This number can help you decide on your investment purchase. But it shouldn’t be the only factor you look at when considering commercial investment properties.
We will take a closer look at what a cap rate is and how you can use it to build your real estate portfolio!
What is a cap rate in commercial real estate?
In commercial real estate, the cap rate is an especially useful number. The cap rate of a property is also known as the capitalization rate. The rate is the product of a formula that real estate investors can use to evaluate the annual return on investment for a property.
When you calculate the cap rate, it is the ratio between the net operating income and the property’s value. It breaks down to the expected percentage of investment return that a property could generate each year.
How to calculate the cap rate
The cap rate formula for commercial real estate is equal to the net operating income divided by the total upfront investment of the property. Here’s what the formula looks like:
Cap rate % = (net operating income/ price of the property) x 100
Calculate the net operating income
Before you can calculate the cap rate of a property, you’ll need to calculate the net operating income (NOI). In order to make that calculation, simply subtract the operating expenses from the revenue of a property.
Determining your net operating income is fairly straightforward. But you’ll need to consider a wide variety of expenses before finalizing your estimate. A few expenses to consider include property taxes, insurance, maintenance, repairs, vacancy losses, and any utilities that you are responsible for. Although there are many more expenses that could arise, this will give you a place to get started. Take the time to think through your net operating income calculation carefully. Otherwise, you might throw off your cap rate calculator through a critical underestimation of expenses.
Calculate the upfront investment
Some commercial real estate purchases are fairly straightforward in terms of upfront costs. For example, if you buy a turnkey building, then you may only need to consider the purchase price.
However, you may plan on making substantial repairs to a property. In that case, you would need to consider the purchase price as well as an estimate for the repairs.
Calculate the cap rate
Once you’ve determined both the net operating income and the upfront investment required, then you can calculate the cap rate for a commercial property.
Let’s take a closer look at a few over simplified examples to get the hang of this math:
Example 1: Retail space in need of renovations
Let’s say that you are considering a property that could be rented out as a retail space. The plan is to buy the property for $75,000. Once you close on the property, you are planning to invest another $75,000 into repairs and renovations for the property. You hope to rent out the property for $2,500 per month. Each month, you plan to spend $250 to keep the property in good condition.
Here’s how to calculate the cap rate on this property:
First, determine the total upfront investment. In this case, you would combine the purchase price and planned repairs. That would lead to an upfront cost of $150,000.
Then, you’ll need to calculate your net operating income. If you plan to bring in $2,500 per month and spend $250 on repairs, that would lead to a net operating income of $2,250 each month. For the year, the annual net operating income would be $27,000.
Finally, you can pull these numbers together. Divide the net operating income by the upfront cost of the investment to determine your cap rate. With that, you would divide $27,000 by $150,000 and multiple that by 100. That leads to a cap rate of 18%.
Example 2: Turnkey office building
Let’s say that you are considering an office building property that is in great condition. The plan is to buy the property for $125,000. Once you close on the property, you are not planning to invest in any additional repairs. You hope to rent out the property for $1,500 per month. Each month, you plan to spend $100 to keep the property in good condition.
Here’s how to calculate the cap rate on this property:
First, determine the total upfront investment. In this case, you would only need to consider the purchase price of $125,000.
Then, you’ll need to calculate your net operating income. If you plan to bring in $1,500 per month and spend $100 on repairs, that would lead to a net operating income of $1,400 each month. For the year, the annual net operating income would be $16,800.
Finally, you can pull these numbers together. Divide the net operating income by the upfront cost of the investment to determine your cap rate. With that, you would divide $16,800 by $125,000 and multiply that by 100. That leads to a cap rate of 13%.
What is a good cap rate in commercial real estate?
The cap rate of a commercial real estate deal can help you determine how quickly you would receive a return on your investment. However, the definition of a “good” cap rate in commercial real estate varies widely by the area.
A higher cap rate will indicate a higher level of risk involved in the deal. That higher level of risk is associated with a higher potential return and the ability to recover your initial investment more quickly. On the flip side, a lower cap rate will indicate a lower level of risk involved in the deal. But you might have less to worry about in terms of a long term return.
A good cap rate for your situation will depend on your individual risk tolerance. Plus, the local market in your investment area will have a unique range of cap rates.
When to use a cap rate in commercial real estate
When you are evaluating the investment potential of a property, the cap rate is a great tool. You can use it to quickly sort through properties to find deals that suit your investment goals. However, it is not the only factor that you should consider.
Beyond the cap rate, you should consider overall risk factors. If the cap rate looks like a good opportunity, then you can investigate the deal further. If a cap rate doesn’t fit into your portfolio goals, then you can move on without sinking too much time into researching the property.
The bottom line
A cap rate is a useful tool as a commercial real estate investor. As you build your real estate portfolio, other factors such as your risk tolerance, condition of the property, and more will come into play. But the cap rate is a great place to start your search.