What Is a Cap Rate, and How Does It Impact CRE Investments?
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Your forays into commercial real estate, or CRE, investing will be fraught with potential language barriers. Although the field may be new to you, rest assured that there’s a well-established lexicon of terminology that investors use to gauge the viability of specific holdings.
The capitalization rate, more informally known as the cap rate, is one such measure. Understanding this ratio might make your CRE experience far more rewarding. Here’s everything that you need to know.
Capitalization Rates Defined
Most people invest in CRE to make money, and the amount of income that a given property generates is commonly expressed as its NOI, or net operating income. This is equivalent to the asset’s returns during a given period minus the costs that you incur by operating it during the same time frame.
To calculate the cap rate on an NOI-producing property, you simply divide the NOI by the property’s sale price or its market value. This gives you a percentage-based measure that represents the ratio of the asset’s useful income to its original or current worth depending on whether you use the current market value or original purchase price:
Capitalization Rate = NOI / Current Market Value OR Capitalization Rate = NOI / Purchase Price
Using Capitalization Rates for CRE Investing
Calculating the capitalization rate of a property provides savvy investors with a lot of useful information. For instance, those who track this ratio on a regular basis can paint a clearer picture of how profitable their CRE holdings are over time. They can also contrast prospective investments to learn which might be the most lucrative.
Understanding Ongoing Asset Profitability
Suppose that you purchase a retail property for $10,000,000. Thanks to its tenants and fees, it might generate $2,000,000 in NOI one year, which would amount to a capitalization rate of 20 percent. If it only creates $1,000,000 in NOI during the following year, the capitalization rate would drop to 10 percent.
By observing the capitalization rates quarterly or annually, you can get a better feel for the real value of your equity and how long it might take you to recoup your initial investment. Such insights often come in handy for people who aren’t quite sure where to invest their CRE money.
Getting a Feel for Your Positioning
Another useful aspect of capitalization rates is that they can help you analyze your assets’ performance with heightened efficacy in light of broader trends and distinct market factors. For instance, it might not be constructive to compare the return on investment of a multifamily residence to that of an office block. Two retail centers of comparable size may exhibit wildly different ROI due to their locations. Capitalization rates help you analyze different investments on an equal footing.
Variance in usage and other factors make it hard to derive a meaningful understanding of comparative incomes when properties aren’t in the same class. Even functionally or physically similar properties might have unique differences that impede your best efforts at making comparisons, so sticking to universal measures usually helps.
Cap Rates Aren’t Flawless
Capitalization rate comparisons may come to the rescue when you’re dealing with fundamentally different assets. This doesn’t mean that you can rely on them in every assessment you make, however.
When it comes to short-term investments, for example, capitalization rates may not exhaustively reflect a property’s true ROI potential. If you haven’t held the asset for very long, you’ll have difficulty calculating its cash flow accurately, limiting the utility of using ratios based on NOI. These assessments can also fall short when it comes to properties that you received as inheritances, gifts or components of other unconventional transactions due to such assets’ lack of purchase prices.
Bear in mind that even when cap rates provide meaningful commercial real estate feedback, they shouldn’t be your only resource. You should also think about how the periodic income that you stand to derive from a property might increase or decline. It’s equally important to keep your calculations current with the asset’s projected value depreciation and need for capital improvements, upcoming maintenance and changing zoning laws.
When you use capitalization rates as a means of gauging new investments, it’s vital to understand that differences in how people calculate NOI can impact the resulting figures. Although performing a percentage-to-percentage comparison of two property’s rates seems fairly simple, investors who list CRE properties might vary in their use of prior NOI or forward-looking returns in their calculations. As you decide what an acceptable capitalization rate looks like, be certain to adjust for these considerations.
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