Last month I wrote about CAP rates as one of the unknowns that I hear people wondering about. I hear time and time again, “What is my property worth?” and “What is a fair price for this property that I want to buy?” Unfortunately, there is no magical formula or answer to these questions. A lot goes into assigning value or worth to property. That where a good Commercial Real Estate Agent can help! This month my newsletter contribution will concentrate of Part 2 of CAP Rates.
When you are buying a home or a duplex, most residential real estate agents and appraisers look at comparable sales to determine a price. They have a wealth of information in the Multiple Listing Service from which to gather that information. No better way to determine a price but by what people, in a recent time frame, are paying for a similar property in a similar neighborhood!
In the commercial property world, all that information is not readily available, and the commercial properties are way too different to match up to one another in many cases. Sure, land in this area might typically go $xx per acre, Warehousing in this area is typically $xx per foot, and so on. But commercial property tends to be more sophisticated and irregular as there a lot of factors that contribute to a commercial property value.
Because of this sophistication and unpredictability, other methods of evaluating commercial property are used. Tools like the income approach and return on investment become very important.
You should know that a CAP rate or Capitalization Rate is a before tax, cash on cash return that an investor would earn if they purchased the property with no use of debt. Keeping in mind from last month, CAP rate is “Net Operating Income (NOI)/purchase price” and is expressed as though it has been multiplied by 100. NOI is “income-expenses” and in this case not all expenses are counted, see your commercial real estate agent for help on this.
So, for example, a commercial strip mall property with high end tenants with an NOI of $80,000 per year and is valued at $1 Million dollars will result in an 8 CAP. So, what does that mean? This is where a business minded Commercial Real Estate Agent will help with determining typical CAP rates for that kind of property, in that area, in that same general time frame.
CAP rates are very practical and useful tools. As a rental property investor, one can use CAP rate to pick a market or property type to invest in, set goals and perform analysis for property acquisitions, or decide to sell an existing property. Basically, a CAP rate helps you make good decisions with statistical backing, and good decisions lead to you accomplishing your overall real estate and financial goals.
Perhaps you come across the property such as the above example and you determine that it is a nice stabilized property earning market rents and the CAP rate is fair for the area, the current time, and for that type of property. It also meets your investment criteria. Therefore, you might consider purchasing that property as you can move right into a easy to manage and money making property right away. The CAP Rate is one tool to use but there are other factors and considerations you must look at.
Is the income on record at Market Value? Take a situation where you find a property, but it has a smaller CAP rate (for that area, at this time, and that type of property), say 6.5, but you and your commercial agent determine the income can be boosted as it is below market value. When done the CAP rate is 8! You determine the risk is workable, the economy is likely to be stable and you can benefit from this situation! This might be a good property to buy!
Interest Rates are another variable impacting a property’s worth. Changing interest rates can also affect CAP rates. As interest rates go up and down, property values can go up and down in some situations. What you can sell the property for changes and so can the CAP rate.
Remember, CAP rates are a tool. You should be evaluating many different statistics gathered from many sources and utilizing tools such as CAP Rate when you are evaluating commercial property. Your greatest asset when trying to determine the worth of a property you wish to buy or sell is going to be a Commercial Real Estate Agent that is comfortable in doing a full analysis of the property. A Proforma Analysis can be helpful if you and your agent think there are some ways to improve a property. Perhaps you must spend money to increase the income. How much spent is worth the resulting income increase? These are all factors to help evaluate the property and your potential purchase or sale. Your best bet is to work with your Commercial Agent to make the best decision!