Capitalization Rates and Commercial Real Estate

Capitalization Rates and Commercial Real Estate

As an FHA MAP Lender, I often deal with a lot of first time buyers of commercial real estate and other people who are relatively new to the business. I appreciate the opportunity to work with such capitalists and enjoy sharing some of the things I have learned over the years. Even with experienced owners, making a lot of money, the purpose, definition and application of cap rates to commercial real estate are not entirely understood. Further, most people don’t know how to calculate a Cap Rate correctly anyway. So let’s talk Cap Rates. A Capitalization Rate is the rate of return one can expect based on a particular net operating income in relation to the purchase price or perceived value. Looking at it as an equation, one would get this: Cap Rate=NOI/Value Let’s take an example: Say you have a property with $100,000 in net operating income. “Net” in this example is rental income and ancillary income less vacancy, skips and after expenses for marketing, management, general administration, utilities, payroll and related, insurance, repairs and maintenance, taxes and reserves. In this example, if the purchase price is $900,000, the Cap Rate is right at 11%. If the purchase price is $1,100,000, the Cap Rate is right at 9%. At a cool Million, the Cap Rate is 10%. Think of it this way: If one buys at $900,000, and assuming no debt, how long will it take to get the purchase price repaid from the property’s operations? At 9 years, the rate of return is 11.11%, say 11%. At $1,100,000, it is 11 years, or 9.11%, or just a...