Hi, this is Frank Chen with REIClub.com, the only site you need as a real estate investor. Today I've got quick video on capitalization (cap) rates.
Common Questions From Real Estate Investors
- How do you know what a commercial property is worth?
- How long will it take to get your ROI?
- What's the maximum I can pay for an investment and still achieve my investment goals?
What is Cap Rate?
Capitalization rate is used to estimate the investor's potential cash flow return on an investment as if an investor paid all cash for the investment property.
It is considered a reliable estimation tool because it incorporates a property's selling price, gross rents, non rental income, vacancy amount and operating expenses.
Simply put, the cap rate is the net operating income divided by the sales price or value of a property, usually stated as a percentage.
Cap Rate = Annual Net Operating Income / Cost of the Asset
Why is Cap Rate Important and What It Tells You
- quick estimation of market value for income producing properties 5 units or more
- projected return for one year
- forces you to find the NOI – cash flow, yield, the expenses
- used to compare other similar properties to see if your deal is good
- more accurate than comparables pulled from the MLS
- Sellers – highest price equates to lower cap rate (yield)
- Buyers – lowest price equates to higher cap rate (yield)
- The lower the selling price the higher the cap rate.
- The higher the selling price, the lower the cap rate.
- From an investor or buyer's perspective, the higher the cap rate, the better.
Once you are able to obtain a market cap rate, you can then use this information to estimate what similar income properties should sell for. This will help you to gauge whether or not the asking price for a particular piece of property is over or under priced.
What Cap Rate Doesn't Tell You
- property history
- property condition
- property age
- Changes in cash flow after 1 year
- Changes in property value – Inflation / deflation
- Below NOI Expenses
– tenant improvement costs
– leasing commissions
– capital expenses (major repair of roof, HVAC, parking lot, structure, etc.)
- Loan expenses
– financing costs (loan interest, points, etc.) - Broker Commisions
Cap rate is a good starting point when you want to quickly compare investment opportunities, but it should not be the sole factor in any real estate investment decision. And always make sure you are doing your calculations based on actual numbers, not “what if” pro-forma numbers provided by a broker.
You still have to consider the many factors that affect the potential growth and decline of the investment, such as the increase in value of the property and any alternative investments available.
I cannot stress enough the importance of performing thorough due diligence in commercial income properties. That alone is what determines the difference between being a true “investor,” and the next “don't-wanter” seller.
Again, this is Frank Chen with REIClub.com. Please take the time to leave your comments for this video below and please subscribe to our YouTube channel so you'll be automatically notified when we upload more quick video tips for you. Take care and good investing.
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