Capitalization Rates or "Cap Rates"

deliberately didn't talk about "cap rates" in the prior commercial article as I wanted the blog to be a very general introduction. I didn't want to scare away people by using terminology, math, or accounting formulas. However, when considering investment property, whether from a seller viewpoint or a purchaser, one must examine capitalization rates, commonly referred to as "cap rate".

Essentially, cap rate refers to the expected net return on a specific property. It is calculated by taking the gross rents (all rents, fully occupied) subtracting vacancies and credit loss (people not paying) to derive effective rents. Then all expenses, specific to the property, are subtracted from total effective rents. Note that income taxes and debt service are not included. The number derived will produce the net operating income for the property. The net operating income is then divided by the required return (for the buyer) to derive a purchase price.

GI-Vacancies/Loss=Effective Rents

Effective Rents -- Operating expenses = NOI

NOI divided by expected return = Purchase Price

This is important to the seller, as well. Investment properties are priced based on cap rates (and a few other considerations). If a property is producing a NOI of $100,000 and the market expects a 10% return for that type of property, the expected sells price is $1,000,000. Thus, the seller should not expect a price of $2,000,000.

While cap rate is a very important component of commercial investment analysis, there are other considerations utilized in making these decisions. Internal Rate of Return, Gross Rents Multiplier, Cost per square foot, etc. are all analysis tools used in the decision making process. A professional who understands these calculations should be consulted when listing or purchasing investment property.

For more information, please visit my website at www.tchurchwell.com or email me at tchurchwell@gsh.com or call Tim Churchwell at (757) 456-1986.