Why you should know about Cap Rates
The capitalization rate, or Cap Rate, is a fundamental concept in the commercial real estate industry. We made a brief rundown on what it’s about so read on to learn more…
WHAT IS A CAP RATE?
The cap rate, often referred to as The Yield, is one of the most popular metrics to measure a property’s expected rate of return based on current income and market value.
Here’s a simple equation dividing the property’s expected annual net operating income by its current market value:
Cap Rate = Net Operating Income (NOI) / Current Market Value
Net Operating Income (NOI) is the value of the net rental rate, or operating expenses subtracted from actual income, and the current market value of the property is calculated using a comparative Market Analysis (CMA).
The basic function of a cap rate is to measure the potential ROI on any given real estate investment.
WHAT DO CAP RATES MEASURE?
It represents the risk associated with an investment: The higher the cap rate, the higher the risk, but also the higher the potential ROI. Inversely, a lower cap rate is indicative of lower investment risk but accompanies a lower payout.
For example, you are an investor looking to purchase a building. The property of interest has an NOI of $120,000 and is being sold at an asking price of $1,600,000. Using the formula and dividing $120,000/$1,600,000 will yield a cap rate of 7.5%. As an investor, this translates to a 7.5% ROI for you.
WHEN TO USE THE CAP RATE
As mentioned, in the commercial real estate industry, investors commonly use the cap rate as it’s proven to be helpful in different scenarios, providing investors with a quick assessment as to which acquisition should be chosen over another potential investment.
For example, suppose you are comparing a property with a 10% capitalization rate acquisition with another property with a 20% acquisition. By simple comparison of the rates, you can already see that one property can give a higher risk premium.
Also, capitalization rates can help investors in trend analysis, giving investors an idea of the direction the market is heading in. For instance, decreasing capitalization rates may indicate that the market values are going up, which may be a sign that the market is heating up.
In respect to Calgary and area CAP Rates, see the chart below. Note how CAP rates have been sliding in recent years.
WHEN NOT TO USE THE CAP RATE
On the other hand, investors should also know when not to use cap rates. Though capitalization rates fulfill the basic calculation of ROI and serve some predictive function, they cannot account for more complex cash flow processes. A cap rate should be used for quick valuations and to understand the real estate market fluctuations on a high level. For deeper understandings and to account for all variations of cash flow systems, you should conduct a comprehensive analysis. Indeed, real estate investment may be tricky. There are a lot of risk factors to evaluate and consider.
Cap rate calculation may sometimes be a multi-tiered process, but it can help your decision-making. If you’re interested in purchasing, leasing, or expanding a business, you probably want statistics that prove the soundness of a real estate investment. At Top Commercial Listings, we know how to accurately calculate these figures and help you determine if a certain property would truly meet your needs. Call Aaron at 403-200-4026 to talk about your next investment and take advantage of our experience, knowledge, and expertise in the Commercial Real Estate market in Calgary.