Let’s be honest: Commercial Real Estate Can be Complex.
This is true in the broad sense of commercial real estate; every category of commercial properties requires a unique set of factors to understand and consider.
When I asked our Broker in Charge at McDaniel and Company what he thinks is one of the most important topics to understand in commercial real estate, his answer was two words: Cap Rates.
Not only is he our Broker in Charge, but he is my teacher, mentor, and most importantly, my Dad.
Here is how Bill McDaniel, CCIM, and real estate professional for over forty years would explain cap rates:
What is a Cap Rate?
A cap rate is a tool used to evaluate the return on your investment for an income producing property.
When determining how to invest in income producing properties, a cap rate is a stream-lined approach that allows for an “apples to apples” comparison among investment properties.
A cap rate gives you an annual return on your investment so your investments can be compared to other investments (stocks, bonds, other income producing properties, etc).
Why Should I Care?
There are many other real estate evaluation methods, but cap rates are an easy measuring tool as you consider various real estate investments.
If you are considering purchasing a shopping center, a multi-family investment, or an office building, a cap rate will provide a stream lined approach for evaluating which choice would provide the best return on your investment.
How is a Cap Rate Calculated?
The basic equation for calculating a cap rate is to take the annual income of the income producing property, subtract all expenses, and divide the purchase price into that number.
Annual Income- Annual Expenses = Net Income / Purchase Price of the Property
Let’s say that X purchases a building for $100,000.
This building leases for $1000 per month.
Therefore, the annual income is $12,000.
Let’s assume expenses are $3000.
Here are the steps:
- Determine annual income
We already determined the annual income is $12,000.
- Calculate annual expenses
We assume that annual expenses are $3000.
- Subtract annual income from annual expenses
- Know your purchase price
The purchase price was $100,000
- Divide the annual net income by the purchase price
$9000/$100,000= 9% return
- Evaluate the cap rate against other investments
The higher the cap rate, the higher return on your investment.
Cap Rates Can Change Based on Several Factors
Mathematically, it makes sense that the cap rate decreases as the price of the investment increases.
A bigger number divided into a smaller number produces a smaller cap rate.
If you pay more money for an investment, and the net income stays the same, your return will be smaller. Alternatively, this means a lower price will produce a higher cap rate.
- Market Conditions-
Tied to the last factor, as market conditions change, price changes; therefore cap rates fluctuate.
In a dynamic economy, cap rates tend to decrease because a higher price is being paid for the investment.
Alternatively, in a weak economy, cap rates will usually rise because the price of the investment is lower.
- Cost and Rental Prices-
It makes sense that lower costs or rising rents will both increase the cap rate of your investment.
Speaking generally, rental prices tend to be higher in a good economy and lower in a weak economy, but there are exceptions.
For example, in a recession, more people may decide to rent instead of purchase a home. This drives up rental prices which increases the annual income and cap rates for investments such as multifamily units.
Like stocks, bonds, and other investments, a higher risk investment will usually provide a higher return while a lower risk investment will usually provide a lower return.
For example, if a national company leases a building and signs a long term lease, the yield on that building will be lower for the investor than a building that is rented to a local tenant on a short term lease.
One Assumption with Cap Rates
Cap rates assume you paid cash for the property.
If there is a loan on the property, the interest rate must be considered.
If the interest rate is lower than the cap rate, the return on your investment is greater.
If interest rate is higher than the cap rate, then the return is lower.
Although the example presented is a simplified version of evaluating cap rates, the basic concept will hold true in more complex scenarios.
A cap rate allows one to look at various types of real estate and determine the return on a property compared to other choices.