Commercial real estate deals involve many obscure terms and abbreviations. There are terms such as Cash on Cash, Net Operating Income, and CAP Rate. Of these, perhaps the most important one to know is CAP Rate.
What is CAP Rate? CAP Rate stands for Capitalisation Rate, which is a measure of the return on investment on a commercial property.
It is important to note that CAP Rate doesn't take into account any debt on the property. This means that CAP Rate is an indicator of returns on investment in an absolute sense. Thus, investors can use a straight-up comparison of CAP Rates of different properties to to help them reach a buying decision, without being confused by the financing on the properties themselves. CAP Rate is not the same as cash flow, which would consider mortgage payments as well.
How is CAP Rate calculated? The CAP Rate of a commercial property is calculated using the following formula:
RENTAL INCOME minus EXPENSES (other than mortgage) divided by PURCHASE PRICE
Let's take a look at an example using the figures below.
Rental Income = $120,000 per year
Expenses = $30,000
Purchase Price = $1,000,000
RENTAL INCOME minus EXPENSES = $120,000 - $30,000 = $90,000
CAP Rate = $90,000/$1,000,000 = 0.09
The answer, 0.09, expressed as a percentage = 9%. Thus, this particular property is said to have a CAP Rate of 9%.
Expenses would include all regular and irregular expenses to be paid in the course of using and maintaining the building. These would include utilities bills such as water, gas and electricity, as well as any and all periodic costs like pest exterminators, minor repairs, etc.
How can CAP Rate help me decide Most investors look at CAP Rate when deciding which property to invest in. A high CAP Rate is desirable, as the higher the CAP Rate, the better the returns on investment. Small investors seeking a suitable purchase would do well to look for commercial real estate with a CAP Rate of around 10%.
CAP Rates of properties vary by area and type - but not always as expected. A shiny new building located in the middle of the city may only manage a CAP Rate of 5%, whereas older buildings in a quieter district may score CAP Rates close to 10%.
Also, property CAP Rates are often specific to market and building types, so it is helpful to survey the market by talking to investors, bankers and brokers to get a feel for things.