Quick Review: Cap Rates can be used as a quick and easy evaluation of commercial property investment deals. Sellers communicate “Cap Rates” to real estate investors so they can get a sense of how profitable a property in currently operating or will operate in the future. It is also a means to quickly compare deals.
As an investor, you must know which Cap Rate the sellers is quoting when you find an investment deal on sites like Loopnet.com. The returns from a commercial investment deal, for example a 20 unit apartment building, come from: appreciation, cash flow, depreciation (tax write-offs), principal reduction and the use of leverage.
Investors, let's continue where we left in “Checking Out Commercial Deals? – Cap Rate Could Mislead You” and start off with a commercial investment case study.
Cap Rates, Sellers & Investment Deals
Picking up where we left off – let's look at that property was listed for $1,000,000 and is currently 80% leased and generates $80,000 NOI. Rents ar $120,000 and expenses are $40,000. Assume that the pro forma income is $100,00 per year when it's 100% lease at current rental rates and that if rents are increase, NOI could be $140,000. Did you know the seller could display three different Cap Rates for the same property:
- Seller could use NOI (net operating income) of $80,000 per year making the Cap Rate 8%. (This the correct way I would calculate the current Cap Rate.)
- The Seller could use NOI $100,00 and advertise a 10% Cap Rate.
- The sellers could use pro forma NOI of $140,00 and advertise a 14% Cap Rate. Although this takes NOI into consideration, it is not the actual NOI but potential NOI
Often properties with the greatest potential for strong appreciation are newer or in good location and are offered at lower Cap Rates. In other words, the are prices higher. On the other end, properties that are in poor condition or have ground leases, are much harder to sell. As a result, a seller my try to attract buyers by advertising a higher Cap Rate. Real Estate Investors beware!
Cap Rates should not be the only factor considered to determine whether to buy and how much to pay for a property but it is a good way to quickly weed out investments not meeting the investor's criteria or to quickly qualify investments that warrant further analysis.
You can learn more about Apartment and Commercial investing over on REIClub.com main site with 8 FREE training videos on commercial investing.