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What's It Worth? - How to Figure Your Cap Rate

Topic: Real Estate Value

For anyone in the commercial real estate industry, the cap rate, or capitalization rate, is an important piece of information. It plays a big part in how much a property sells for and helps tell you what you should pay. Commercial real estate investors, as well as brokers, agents and other professionals, should know what a cap rate is and how to determine it - whether they've been working in the industry for a long time, or are just coming in. Here's some basic information to help.

When it comes to commercial real estate, we can think of the cap rate as a number summarizing the way a few important aspects of a property interrelate. These are the net operating income and the price. For instance, a cap rate of eight would represent an annual return of seven percent on your initial investment, before income tax and mortgage payments. This rate is often important in determining what a fair price to pay for a given property might be. If you want to be sure you're making a certain return on your investment, you make it the target cap rate when you buy. It tells you what the maximum you should pay for a property is.

Unlike a gross rent multiplier, which is a cruder way to decide what to pay for a property, the cap rate also takes expenses into consideration. The net operating income mentioned above is how much money is left over after rent has been received and you've paid the month's operating expenses. These are things like utility bills and fees required to keep your property in good condition. This makes it easy to tell if expenses are likely to eat up all your profits.

Your cap rate for a given property is found by taking the net operating income (or NOI) for a given period of time and dividing it by the price you've paid, or the price you're thinking about paying. Most people use the NOI of the first year in this formula. The number is then multiplied by a hundred, which is why cap rates are expressed in whole numbers, not percentages. Higher cap rates are better than lower ones for the person making the purchase. The seller, of course, wants to get a higher price, resulting in a lower cap rate for the buyer.

So, if you're thinking about buying commercial real estate property, this kind of information could be a big help. Commercial real estate investors can use the cap rate on similar properties in the same area as the one they're thinking of buying to tell them if they should buy at the price given. For a very general idea of good pricing, find out the average cap rate of similar properties, and make it the lowest you're willing to pay for. Just divide the net operating expenses by your desired cap rate, and multiply the result by one hundred to get the price you should be willing to pay for the property. This isn't the most accurate method, however.

One thing you should remember is that the cap rate doesn't take into account all the building expenses. It just deals with operating expenses. That means it leaves out mortgage payments (also referred to as debt service) and any other fees you might incur. However, what the cap rate can do is isolate elements that are related to the property directly. Loan terms will tend to vary a lot from one loan to the next. That makes it hard to include your mortgage expenses in this equation. The cap rate tells you what you'll be spending on the building specifically, versus the percentage you're likely to make on your commercial real estate investment.

To get an accurate cap rate, you'll have to know the real income and expenses of the property you're thinking of buying. Remember that the most important part of valuing a property is what it's worth to you, rather than another investor or an appraiser. The estimated cap rate of a commercial real estate property is an important number, but it shouldn't be the only number you pay attention to.

Verify the income for a commercial real estate property when you do your calculation, and the expenses if possible. If you're working with incorrect numbers, you won't get an accurate cap rate. This means checking rent rolls and verifying the property's expenses with third party suppliers. You probably won't be able to find out everything about the expenses and income of a property, but you might be able to get enough information to develop a good idea of how accurate the number you're being given is.

You'll also need to know the terms of the financing that are available to you. Terms for commercial real estate loans can vary greatly from those of residential real estate loans. Use this information to develop the loan or mortgage constant. This is the number that, when you multiply it by the amount of the loan, tells you how much you need to pay to repay the debt fully over the period of the loan. It's not an interest rate. It's a number derived from an interest rate and an amortization period, and it should be used instead of a simple interest rate when you're looking at the cap rate. You can't pay just the interest on a loan and expect to profit!

The formula for deciding the loan constant is the annual debt service divided by the loan principal amount. Once you've determined this constant, decide what your equity constant should be. Start by determining the return you want on your money (the cash-on-cash return, equity cap rate, cash-throw-off rate or equity dividend rate, depending on who you're talking to). This percentage is the equity constant. Once you have this number, you can put all this information together to get a weighted average that'll help you decide whether a commercial real estate property's worth it in the end.

Take the loan to value (LTV) debt ratio, and multiply it by your mortgage constant. Add this number to the number you get when multiplying the LTV equity ratio by the equity constant. That gives you your personal derived cap rate, which will be more accurate than just comparing similar properties. Convert this number to a percentage to tell you what the cap rate you'll need for a given commercial real estate property is. That allows you to calculate the maximum purchase price you're willing to pay with a lot more accuracy than just picking a cap rate out of the air.

Remember that even the most accurate calculations aren't a magic way to ensure profit. The cap rate is just a place to start, and it's not the last word in valuing a property. Many factors can be responsible for pushing the value of commercial real estate up or down, including deferred maintenance, comparable sales in the same area, market conditions both generally and locally, and how secure your income stream will be. The more risk or effort required to keep an income stream going, the greater return you'll want on your equity. That changes your personal cap rate, and the value of the property. Don't stop your analysis of the price after making your calculations - due diligence is still vital to your success. However, used correctly, cap rates are an important tool.

About the Author: Anthony Seruga and Yolly Bishop

Tony Seruga, Yolanda Seruga and Yolanda Bishop of Maverick Real Estate Investments, Inc. work with builders, developers and other players in the commercial real estate industry to acquire and develop properties. They use progressive investment strategies that have proved extremely profitable. In addition to their own deals, they teach both seasoned and inexperienced investors how to be big players in the game. Visit the website for more info.

06/30/2008
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