What is Your Building Worth?
If you’re thinking of selling your commercial building, the buyers of commercial property are primarily interested in the income the building generates. The value of a commercial building is directly tied to its income and the capitalization rate for the area. The capitalization rate is a convenient tool used in commercial real estate to understand the relationship between the asking price of a commercial property and its net income. The cap rate is a simple mathematical ratio. Divide the yearly net operating income (abbreviated NOI) by the asking price or appraised value of a building. The resulting percentage is what you’re looking for. For example, a commercial building on the market with an asking price of $1,000,000 and a net operating income of $80,000 has a cap rate of 8 percent.
Like any formula, it can be used to yield all sides of the equation. So if you know that a building listed at $1,500,000 has a cap rate of 7 percent, you can presume the net operating income of that building will be $105,000 (or close to it).
Likewise, suppose the net operating income of your own building is $90,000, and you want to determine what price you can get for it. Comparable properties in your area are selling with an average market cap rate of 10 percent, so you would price your building somewhere around $900,000.
What Is NOI?
To get a full understanding of the cap rate, you need to know what net operating income means: it is gross rental receipts minus operating expenses. These include all property tax, maintenance, repair, management, insurance and utility costs necessary to keep the building operating and fulfilling the lease obligations to the tenants. Aside from an accountant or financial specialist, there are several tax calculators and estimators available that can help determine your net operating income. They do not include debt service, which would be your monthly mortgage payments of principal and interest.
Experienced investors understand both the advantages and limitations of using the cap rate to compare and evaluate commercial properties. The rate of an individual property is not very meaningful in itself; you must know the market cap rate before you can compare properties in any geographical area.
Market Cap Rate
The market cap rate is a useful tool for understanding commercial real estate markets and comparing properties. You can learn market cap rates in a particular area from knowledgeable real estate brokers, lenders and appraisers. They will all have access to prices of properties that have recently sold or are currently for sale.
So how does the cap rate serve you? It helps you better understand your market. It helps you learn whether the listed price of a property for sale is in line with other buildings in the area. It can help you ask better questions. For example, if the cap rate seems low to you, it’s a good idea to find out why. Is the owner just setting an unrealistic asking price, or does this building have greater value or potential than others for some reason?
Market cap rate can also tell you in general terms how desirable the geographic area is perceived to be. The lower the cap rate is, the higher the asking price of a property will be in relation to its income potential. In west coast metropolitan areas such as Los Angeles, San Francisco and San Diego, the cap rate is much lower than in most cities in Midwestern or southern states.
A market cap rate that is going down may indicate a strong seller’s market, which could mean a commercial property “bubble” is developing. On the other hand, a cap rate that is growing larger could indicate falling property values in an area, perhaps due to increasing crime, economic woes or a perception of lowered desirability. Both scenarios require a lot of caution, as each change could indicate higher risk for investors over the long term.
How does the cap rate not serve you, and what are its disadvantages? It does not tell you if a property is a good deal for you. This is something you must find out by getting to know specific facts and figures about the market and about any building that interests you. This requires a lot of work: both researching on your own and talking to experienced, knowledgeable people. What are the average square-foot rental rates in the area for office, retail and industrial properties? What are the average vacancy rates? Are rents, vacancies and property values trending up or down? How is the local economy doing, and are things getting better or worse in the near future? What about long term?
Before investing your hard-earned cash in a commercial property, you must examine the income statements and other financial reports for the current year and several past years. You must read the existing leases and know your future obligations to all of the tenants. You must have a full understanding of the cost of debt, your borrowing power and if lenders are eager to loan money to you. And of course, no investment should be made without a thorough physical inspection of the property.
Despite its limitations, the cap rate can be a very quick, handy and useful tool for evaluating commercial properties as long as you understand its best use. Most investors would feel lost without it, especially when getting to know more about potential investment opportunities.