When diving into the world of commercial real estate from residential, one of the first new terms you will come across is the capitalization rate or cap rate. While this term is most often thrown around when discussing the value of a property in a given market, many folks are unaware of how it is derived. Today we will add some clarity to this particular piece of real estate terminology.
It’s important to remember that when purchasing residential real estate, the primary driver behind the cost of the property is comparables. This means that the value of the property is based upon the amount that other buyers were willing to pay for similar properties in a given location within the immediate past.
When considering the value of a commercial property, the approach is fundamentally different. This is because the primary purpose of commercial real estate is to produce income for the owner. The challenge however is how to compare a property’s income generation at a particular purchase price considering that different owners will use different debt structures to purchase the property leading to varying results depending on the amount of leverage used, the interest rate and the amortization schedule. This leads us to develop a term that relates the income of a property to its returns based on a cash purchase. This will allow us to make identical comparisons between properties regardless of the debt that is used to finance them. This of course is the cap rate and is defined as the net operating income of the property (NOI) divided by its value as shown.
The NOI is defined as the gross income of the property minus its expenses not included debt service since our goal is to have a term that is independent of the debt used.
Therefore, the cap rate provides us with a way to describe the rate of return for a property at a given purchase price which can then be used when comparing different properties. For example, if a class C multifamily property generates $100,000 in income after expenses and sells for $1.67M, then it would be a 6% cap market for C class multifamily properties in that area. This means that if a similar C class multifamily property was listed for sale shortly thereafter which has an NOI of $150,000, then we would expect the sale price to be around $2.5M.
This cap rate is useful not only for valuation but also for understanding the characteristics of a given market. If class C properties in city “X” are selling at a 6% cap rate but in city “Y” the same class of properties are selling at a 7% cap rate, then we would understand that an investment in city “Y” would be more cash flow oriented whereas an investment in city “X” would be more focused on appreciation since the cap rate is more compressed (lower) in city A.
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