When you are looking at a commercial real estate deal you will hear terms such as “Cash on Cash return”, “Net Operating Income” or “NOI” and “CAP Rate”.
If you are new to commercial real estate these terms may be foreign to you, so lets get you into the swing of things by teaching you one of the key real estate investing terms for commercial real estate.
CAP rate stands for “Capitalization Rate” and measures the return on an investment in a commercial building. The CAP rate can confuse a new investor because it ignores any debt on the property. That is helpful because it shows the return on the investment in an absolute sense and allows you to compare investment alternatives in different buildings without being confused by the financing on the property, which can muddy the analysis. CAP rate is NOT the same as cash flow, which would take into consideration mortgage payments.
CAP Rate is calculated by taking the income and deducting all expenses other than the mortgage, then dividing that into the purchase price. For example:
If you had rental income of $120,000 per year, expenses (other than mortgage interest) of $30,000 per year you would have $90,000 per year leftover. The expenses that you include are regular expenses like electric, gas and oil paid by the landlord as well as irregular expenses like periodic repairs and maintenance.
In the example above, if you paid one million dollars for the building and had annual cash flow after expenses other than mortgage interest of $90,000 then you would have a cash return of $90,000 on a million dollar investment – which would represent a nine percent return. ($90,000/$1,000,000 = 9%).
CAP rate is a good way to compare investment alternatives. The higher the CAP rate the better because a higher CAP rate refers to a higher return for you.
Retail priced properties have CAP rates that vary by area and type of property. CAP rates can be as low as 5% – for example a unit of Goldman Sachs is asking $42 million for the 250 Unit Palladium in Scottsdale Arizona – a beautiful class “A” apartment building in a hot rental market or CAP rates can exceed 10% for class “B” and “C” apartment buildings in less desirable cities and in older buildings.
In other classes of buildings that are also class “A” CAP rates can be higher. For example a Wells real estate partnership (REIT out of Georgia) is the 275,000 square foot Highland Landmark 3 in Downers Grove Illinois at a 7% CAP rate. That building is 97% occupied and is also a class “A” building having been built in 2000 and featuring modern system, aesthetics and functionality.
CAP rates are market and building type specific so you will need to learn your market by looking at asking prices, comparable selling prices and speaking with market participants (investors, bankers, brokers) to see what your market is like.
For most small investors your best purchases will be class “B” apartment buildings where CAP rates are at least 10%. You will note that a 10% return is MUCH higher than any bank will give you and probably the highest return on a safe investment that you can find today. That is, in a nutshell, why cash flow investing in apartment buildings and other commercial properties is so attractive.