Real Estate Investing - Capitalization Rate
Capitalization rate is the percentage rate of return estimated from the net income of a piece of property.
The capitalization rate is the rate of return that a property would generate if it was purchased with all cash and not financed. So, if you were to pay $1,000,000 cash for a building and it generated $100,000 in net income, your “cap rate” would be 10%. See Below:
Net Operating Income (NOI): $100,000
(divided by) Purchase Price or Value: $1,000,000
(equals) Capitalization Rate: .1 OR 10%
Capitalization rates are used to value commercial properties in relation to other comparable properties (“Comps”) in the area. As a simple reference point, you want to purchase properties at a higher cap rate than the comps in the area and sell at a lower cap rate than when you made the purchase. The reason for this, is because the lower the cap rate, the more the property will be worth. For example using the information above, you purchase a building at a 10% cap rate and made some repairs and upgraded the quality of tenants and the quality of the building. Let’s say that buildings in the area that are similar to your newly renovated building are selling at a 8% cap rate. To make the example simple, we will assume that there has been no increase in your Net Operating Income. At an 8% cap rate, your building would be worth $1,250,000. Below is how we came up with that value.
Net Operating Income (NOI): $100,000
(divided by) Capitalization Rate: .08 OR 8%
(equals) Value: $1,250,000
Now I kept these numbers simple for illustration. In reality if you made renovations to a property and increased the quality of tenant and quality of building, your net operating income would increase as well, which would make the building worth more than $1,250,000.
When you are doing your due diligence on investment properties, you always want to know the “cap rate” that comparable properties are selling at, so you can attempt to acquire a building at a higher “cap rate” than the current market. This will give you the opportunity to renovate and reposition the property so that you can increase the equity in the property, similar to the way residential real estate investors purchase properties below the market comps so they can fix them up and have additional equity built into the property.
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