So you have probably heard of the term R.O.I. or Return on Investment, but if you are looking into purchasing an investment property, especially if it is a commercial property, you may be wondering what a "Cap Rate" is and how it is calculated. I will break this down for you and don't worry, there isn't too much math involved!
A Capitalization Rate or "Cap Rate" is derived from taking the Net Operating Income (NOI) of the property divided by the Price. People often refer to their ROI in more general terms and for a wide variety of investments. In real estate, perhaps they are using the term ROI because they are not familiar with underwriting the financials for various property types and they are not taking into consideration details on expenses, reimbursements, a vacancy factor where applicable, management fees, reserves, CAM, future rent increases, etc. which would be a much less accurate way to analyze a property's value. Here is a very basic scenario where we can take a look at the Cap Rate component.
Example:
Daniela is looking at purchasing the real estate for a new quick service restaurant (QSR), in the Tampa area called Food to Table. Since this would be an investment property and she is not interested in being an owner/operator of this location, she would want to understand the financials for this tenant during her due diligence period or even prior to making an offer if possible. Seeing as Daniela is a savvy investor, she is working exclusively with Clout Realty & Investments for her purchase and her Agent obtains the financials from the OM for the Food to Table tenant for her.
After reviewing the figures together, it appears that this QSR has a current NOI of $95,000/year. The Seller has the property listed on CoStar for $1,300,000. Daniela is looking to acquire a property with at least 7 years remaining on the base term of a NNN lease and ideally a corporate guaranty at a 8%+ Cap Rate. The lease type, term and guaranty check out after their review of the information provided in the OM. What purchase price would Daniela need to offer to achieve the Cap Rate she is looking for based on the current NOI?
NOI $95,000 / Asking Price $1,300,000 = 7.31% Cap Rate (Asking)
Daniela asks her Agent with Clout Realty & Investments to draw up a Letter of Intent for a purchase price of $1,180,000, or a 8.05% Cap Rate ($95,000 / $1,180,000 = 8.05% Cap Rate) and signs off on this offer right away so she does not miss out on this stellar opportunity!
Because this is an example regarding Cap Rates, we did not go into detail about the other very important components and terms for an LOI on a property. You can read more about this topic here.
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