If you’ve ever looked at Commercial Real Estate, chances are you’ve seen the term “cap rate”. But what exactly is the importance of this number?
The cap rate (or capitalization rate) shows the rate of return from an investment property. It’s a number used estimate the potential investor’s rate of return. Analysts calculate the cap rate based on the net income of the property.
How Do you Calculate the CAP Rate?
The capitalization rate is not a value obtained easily. As a professional opinion, it’s commonly seen as a very negotiable number. The best way to reach one is using a professional business valuator.
Before determining the cap rate of a particular property, a few pieces of data about the potential investment are required.
Net Operating Income
The Net Operating Income, or NOI, is the final annual income achieved by the property. It is determined by taking the sum of all sources of income (rent, mineral rights, etc) and subtracting the expenses of managing the property.
Current Market Value
When calculating the cap rate, there are essentially two schools of thought. The first is that the property’s value should be considered in the current market. If the property has not recently been involved in a transaction, the current market value can be obtained through comparisons.
Sale comparisons, (also referred to as comps) is transactional data compiled from sales or listings similar to the property. To qualify as a comp, the property should be similar in size, location, and construction as the property in question. Typically a comp is calculated by a REALTOR, in cooperation with a business valuator.
Cap Rate Formula:
The general formula for the cap rate is:
cap rate = net operating income / current market value
Illustrating the Point
Let’s say that there is an income property listed for sale at $2,000,000. If the advertised cap rate is 10%, then a simple calculation can be done to estimate the annual income.
$2,000,000 * 10% = $200,000/year
In this scenario, it has been determined that the potential investor would see 10% of his investment returned per year, or $200,000. After 10 years, the investor could potentially have recovered his entire initial investment while continuing to grow.
The Risks of a Cap Rate
The single biggest risk of a cap rate is its reliance on income consistency. Economic shifts, political unrest, and a community’s GDP all affect the potential for the property in question to consistently achieve the annual income. It is for this reason that the estimation of a property’s NOI not be taken lightly.
ReaLawState’s team of professional Toronto Realtors, integrated with expert legal service from seasoned lawyers can assist you with calculating the cap rate for your next potential property. Contact us today.