Investor's Corner - What is capitalization (cap) rate in a commercial property?

For an investor, or anyone that is considering purchasing commercial real estate, the most common question that needs to be answered is this; WHAT IS THE CAP RATE?

What does that even mean?

Simply put, capitalization is the process of converting the income of a given property into a capital value. A capitalization (cap) rate has more than one rate embodied in it (i.e. the discount rate and the recapture rate).

There are two different types of capitalization in the CRE market; direct capitalization and yield capitalization. For the purpose of simplicity, we would focus on direct capitalization as not only it's more widely used, but also it is quite simple since it takes a snapshot of one year's income and expenses to determine a value based on an appropriate capitalization rate.

The formula for calculating the cap rate of a property is this:

Cap Rate = Net Operating Income (NOI) / Property Value

As you can see, each aspect of this equation can vary inevitably based on market fluctuations as well as personal preferences, however, typically two things are considered when determining the right cap rate: investor analysis and market research.

As mentioned, a cap rate also indicates the recapture rate which means the rate at which your investment will be recovered. For example, a 10% cap rate means that it will take around 10 years for you to recoup your investments in the property (also consider the compound effect).

To make it easy peasy, let's give an example:

Suppose you are looking at a property that is generating $150,000 in gross income and has about $40,000 in expenses and the seller is asking $2,000,000 for this property. This is what needs to be done:

First, calculate the NOI by deducting the expenses from the income:

150,000 - 40,000 = 110,000

Now, divide the NOI by the asking price:

110,000 / 2,000,000 = 0.055 or 5.5%

Your cap rate is 5.5%. Now the burning question would be whether this cap rate is acceptable or not. This depends on many different things that need to be taken into consideration (e.g. interest rates, market cap, type of property, investor's preferences, etc.). Always consult your realtor for this if you don't have enough experience in the field.