Understanding capitalization rates and how to use them has become an important skill in fast-paced commercial real estate markets. Investors must know how to valuate a property quickly and accurately to take advantage of opportunities before they disappear. A capitalization rate, or cap rate, helps in making an informed decision.
What is a cap rate? The CCIM Institute, a recognized authority in commercial real estate, defines a capitalization rate as “a percentage that relates the value of an income-producing property to its future income.” This means a cap rate offers a snapshot of what a property value is today, based on current incomes and trends. A cap rate differs from a return or yield because it measures present value and not future earnings. In addition, a cap rate doesn’t factor in the cost of income tax liability or debt service. Since properties may or may not be financed, a cap rate could offer the best tool to use. With so many different types of commercial properties available, the less variation comparable properties have, the more accurate the comparison.
How do you calculate a value from a cap rate? A cap rate is one of two parts to a valuation calculation. The other part is the income of the investment property or net operating income. This number is calculated by adding all potential income (rents) less a vacancy factor and then subtracting operating expenses, not including debt services and depreciation. The number left will be the net operating income. The NOI tells the investor how much money the property has coming in on an annual basis. By dividing the NOI by a cap rate, an investor can see the current value of a property.
How do you determine an accurate cap rate? There are many different sources, and most focus on larger markets. These could be less accurate in a tertiary market. The best source would be a local commercial broker with expertise within that specific market or property type. Their information will most likely be based on local sales and current market trends and offer the best source of expected cap rates. Commercial brokers study recent sales and leases as well as properties on the market to identify trends and make it easier and faster to provide information.
Let’s put this knowledge into practice. Grand Junction typically experiences cap rates between 7 percent and 9 percent, while cap rates range from 6 percent to 8 percent in Denver and 4 percent to 6 percent in California. This means an investor purchasing properties producing the same income would have to pay more in some markets than others. Using the markets above to produce the same income, an investor could pay $1 million in Grand Junction with a 9 percent cap rate, $1.29 million in Denver with a 7 percent cap rate and $1.8 million in California with a 5 percent cap rate. These numbers demonstrate the importance cap rates play in calculating the value of an investment property. The illustration does not, however, take into account the deferred maintenance that also affects value.
As potential property owners, accurate valuations are critical for making the right decisions. A valuation could change every time a comparable property is sold, so it’s important to routinely evaluate a property’s value. This could be an indicator of the right time to buy or sell and also offer the investor a huge advantage.