Dear Mr. F.
Everything that I read about buying and owning commercial real estate references “Cap Rate.” What is “cap rate” and what is its importance to the investor?
Thanks for writing me and for authoring such a good question. The actual term is capitalization rate but mostly everyone uses the abbreviation. It is a standardized valuation method using the ratio of Net income to selling price. By way of example, consider an investment that is netting [after all expenses] $10,000 and is available for sale at $200,000. A prospective investor would calculate the property by dividing the net return [$20,000] by the sales price [$200,000] and compute that the prospective cap rate is 5%!
Cap rate is a simple tool to measure return and to compare properties against each other. Generally the difference in cap rate between similar properties will be explained by differing inherent risk of the tenancies and the term remaining on the underlying leases.
As an investor, you can use Cap Rate to compare your intended acquisition to others that have occurred in that market. You can also follow trends within that marketplace, perhaps giving you a sense of where investment properties are headed in the future.
A quick warning, however … cap rate is best when used for comparing consistent cash flow and is thus highly emphasized in offerings such as net leased investments and rarely used where rents fluctuate greatly and there is a high risk for tenant turnover.
I hope this helps get you started. Please let us know how your efforts to become financially independent progress.
Brian FieldingRead More