Many real estate investors searching for deals on Loopnet are running across properties listed by “Cap Rates.” We've seen that Cap Rates can be used to determine value if the income from the property is known. However, making an investment decision solely on Cap Rate can mislead you into purchasing the wrong property.
When a property produces $100,00 of NOI, if the price for that property is $1,000,000, based on a 10 Cap. Additionally, your payment will be lower than if you had paid $2,000,00 for that property, which equals a 5% Cap Rate, right? That's easy. Here, NOI is the same, but the payment will differ based on price and the amount borrowed. So, for simplicity, the higher the Cap Rate, the greater the cash flow.
Cap Rates can be used as a quick and easy evaluation of commercial property. Experience investors often look at the cap rate to screen out properties with low NOI (net operating income) relative to the price, as those properties may not produce enough cash flow to make the mortgage payment.
Seller will quote Cap Rate differently and real estate investors must determine which type of Cap Rate is being advertised by the seller. There is the Actual Cap Rate which is based on the current NOI of the property. That means that the Cap Rate is bases on the actual NOI the property is currently producing and assumes that no changes to that number will occur.
Sellers will sometimes quote Pro-Forma or Potential Cap Rate to reflect what the purchaser will receive during their first year of operations after certain changes have been made.
What this means is that after purchase, with certain changes made (increase in rents or decrease in expenses in some manner) the property could potentially yield a greater NOI. When the seller has quoted a pro-forma or potential Cap Rte and it is on the potential NOI that price is being determined.
Let's say that a property could potentially generate $100,000 NOI with zero vacancy (100% leased). If the asking price is $1,000,000 for those cash flows (NOI) then the Cap Rate is 10%.
On the other hand, let's assume that the property is actually only 80% lease and therefore only generating $80,000 NOI. If the asking price is still the same $1,000,000 for these lesser cash flows (NOI), the Cap Rate or return is only 8%
The debt service on the $1,000,000 is the same in both examples, but the amount of the NOI from which to pay the debt is less in the second example. Again, the higher the CAP RATE, the greater the cash flow. The greater cash flow, the more likely you will find a lender who will loan you money for purchasing.
I know its a lot to soak in…..I will continue “Checking Out Commercial Deals? – Cap Rate Could Mislead You” with a Part 2 and include some more case studies.
You can learn more about Apartment and Commercial investing over on REIClub.com main site with over 40 articles and case studies on commercial investing.
Have a GREAT investing kind of day!