Trying to understand common commercial real estate terms can sometimes feel like deciphering a foreign language. What is Cap Rate, Core Factor, Triple Net Lease, 1031 Exchange, or Tenant Improvement Allowance (TI)? It’s enough to make your head spin. But it’s important to know what you’re looking at when comparing commercial properties.
In this article today, we’re going to cover one of these terms – Cap Rate or Capitalization Rate?
What is Cap Rate?
To help you better understand the intricacies of Capitalization Rate, here’s United Development Realty Founder and CEO Charles Peacock as part of our What’s That Wednesday short video series, which tackles frequently asked questions about the commercial real estate market.
Charles Peacock: What is a capitalization rate? A cap rate is a metric used in commercial real estate to describe the rate of return on an investment property. In most markets, it’s the net operating income divided by the market value of the property. So, let’s say we had a million-dollar property generating a hundred thousand dollars in net operating income. We will say that this property has a 10 percent cap rate. There are a lot more factors when investing in real estate than just the cap rate. An investor should work with an experienced commercial broker that will give them the help they need in researching each opportunity. The cap rate is an important tool that gives us a rate of return comparison and also would eliminate properties quickly that we know are not something we’re interested in. The rate of return is not our requirement. Thank you. We’re always here to help!
Further Understanding Cap Rate & Why It Matters
So, what is cap rate? Well, it’s the most popular way to measure the return on investment (ROI) or profitability of a potential real estate investment over one year (assuming the property is purchased outright and not on loan). It’s also a handy way of estimating how long it will take to recover your initial investment. For example, a property with a 10 percent cap rate will take roughly around 10 years to recover your investment.
The formula for determining capitalization rate is pretty simple. You take the Net Operating Income (the expected annual income generated by the property after factoring expenses) and divide that by the Current Market Value (present-day value of the property). And that will give you the Cap Rate. This ratio is expressed as a percentage.
Capitalization Rate = Net Operating Income / Current Market Value
Let’s do some quick comparisons to show how capitalization rate works when comparing multiple commercial properties.
- Property 1: The current market value of this property is $1 million. Expected rent for the property is $100,000 annually, and expenses total $20,000. So, our net operating income is $80,000. This gives us a cap rate of 8 percent.
- Property 2: The current market value of this property is $1.5 million. Expected rent for the property is $120,000 annually, and expenses total $25,000. So, our net operating income is 950,000. This gives us a cap rate of 9.5 percent.
In this example, property 2 would offer stronger returns, with a 9.5 percent cap rate. But does that make it a better investment? Of course, real estate investment is anything but black and white.
“Typically, investors view properties with a lower cap rate as less risky but should expect a longer timeframe to recoup their initial investment,” says Sarah Sharkey, Rocket Mortgage. “As an investor, you should take some time to consider what an acceptable cap rate is for properties in your portfolio. With a number in mind, you can quickly pass on properties that don’t meet your risk tolerance.”
And while capitalization rate is a great tool for quickly comparing the relative value of investment properties, it should not be used as the sole factor when considering potential investments.
“Other factors, including the property’s individual characteristics and location, should also be taken into consideration,”says Sharkey.
At the end of the day, the best way to ensure you are making a smart real estate investment is to work with an experienced commercial real estate broker, like United Development Realty.
United Development Realty is Here to Help!
Whether you’re still struggling with that big question – what is Cap Rate – or you just need a little extra guidance, partnering with the right broker can make all the difference when looking at investment properties. While it is impossible to foresee every possible issue with a property, an experienced broker, like United Development Realty, can help ensure you make a wise investment. We are a licensed and experienced commercial real estate broker in Maryland specializing in real estate consulting. We start with you: your vision, your objectives, your goals. Then, we assist you through a tailored package of services to locate a property that fits your vision.We begin this process by listening. Only with a complete understanding of your unique needs and goals can we tap into our extensive network of property owners and developers to match your requirements with the ideal space. Please call our office today (locations in Bethesda 240-221-1976 and Fells Point 410-522-1632) to get in touch with a licensed broker.