As the real estate market begins to stabilise in markets across the country, more and more people are beginning to explore investing in commercial real estate once again. To effectively invest in commercial real estate one must become comfortable with the terminology used in valuation techniques. Today I figured I would give a brief description of what a Capitalisation Rate, or better known as “Cap Rate” is and how it is used to value income producing real estate.
So what’s a Cap Rate?
By definition, a Cap Rate is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. One common mistake made is using the property’s total revenue rather than its NOI (Net Operating Income) which includes all property level expenses other than debt service and depreciation (NOI= Revenue – Operating Expenses).
As an Example:
If you purchase a property for $100,000 and it earns $15,000/year Revenue but has $5,000 operating expenses (taxes, property maintenance, etc) your actual Cap Rate would be 10%, however the common error would be to use the higher revenue number giving you a 15% Cap Rate.
Correct Calculation: $10,000(NOI)/100,000(Purchase Price)= 10%(Cap Rate)
Incorrect Calculation: $15,000(Rev)/$100,000(Purchase Price)= 15% (Cap Rate)
Now that we have defined how to calculate a Cap Rate and its strict definition the real question is what does it mean to investors?
The higher a Cap Rate the higher an investor can expect to earn from their investment. Usually the Cap Rate will also imply a bit about the market – in general, the lower the Cap Rate the nicer the asset e.g. an ocean front duplex in Bondi would have a much lower Cap Rate in comparison to a duplex located in Castle Hill.
Investors use Cap Rates in markets to allow them to compare similar income producing products. Analysts assign a Cap Rate to an area and then apply that number to properties NOI to ascertain a value.
While there are many other aspects to Cap Rates and their effects on real estate, one last point I would like to mention is that a small adjustment in a Cap Rate will have an exponential affect on a property’s value.