Capitalization rate or the Cap Rate – what is it? This is one of the most frequent questions that investors ask themselves when investing in commercial real estate, along with, “how do I know what a commercial property is actually worth?” and “how long will it take for me to get my money back or the ROI the Return On Investment?” And the classic question: “What’s the maximum that I can pay for this property and still have it be considered a good investment?”

The answers to all of these questions can be found by figuring out the cap rate. The cap rate is used to estimate the investor’s potential return on investment as if they paid all cash for that deal. It’s considered a reliable estimation tool because it actually incorporates a property’s selling price, the gross rents, non-rental income, vacancy amounts and operating expenses. Simply put, the cap rate is the Net Operating Income or the NOI divided by the property’s value or the sales price. This number is usually stated as a percentage.

Cap Rate (%) = NOI / Sales Price

Allow me to further elaborate on the subject with questions such as: Why is the cap rate important? And what exactly does the cap rate tell you?

First of all, it is a quick estimation of the market value for income producing properties such as commercial properties or SFR Portfolios – packages of Single Family Rental properties; typically defined as 5 units or more. It also shows you the projected return for the first year of that investment. But more importantly, it also forces you to dig deeper to find out what the actual NOI is. Which includes figuring out your total income, cash flow, total expenses and how they are accounted for; all very important values when determining important real estate investment calculations. Most investors use the cap rate to compare other similar properties to see if the deal is any good. Some say it’s actually a lot more accurate than “pulling comps” or searching for comparable sales that are pulled from the MLS systems.

As a seller, you’re naturally wanting to sell at a higher price with lower cap rates. And as a buyer, you’re looking for properties that are lower priced and have higher cap rates. Let me rephrase that – the lower the selling price, the higher the cap rate and the higher the selling price, the lower the cap rate. From an investor buyer’s perspective the higher the cap rate the better. Once you’re able to obtain an accurate cap rate you can then use this information to estimate what similar income producing properties should sell for. This will actually help you gauge whether or not the asking price or purchase price for a particular property is over-priced or under-priced. As you can see, knowing the actual cap rate of an investment property is an important and incredibly powerful piece of information for real estate investors.

So what does cap rate not tell you?

It does not tell you the property’s history, the condition of the property, or how old it is. It also does not indicate what changes are going to happen (whether planned or not planned) to the cash flow or property value after the initial year. And there may be a significant number of changes that can happen; some may be due to inflation or deflation of the market or the current housing supply and demand. It also does not include broker commissions and other acquisition costs such a closing costs. And it does not incorporate your financing expenses such as your loan costs, your loan points, the interest, the principal, loan fees and etc. And last but not least, it does not include other non-operating or “below NOI expenses” such as your tenant improvement costs, leasing commissions, and capital expenses or major repairs such as repairs that are done the roof, the HVAC air conditioning, the foundation, the parking lot, the structure and etc.

With all this said, understand that figuring out the cap rate is a good starting point when you want to quickly compare investment opportunities. However, it should not be the sole factor in any real estate investment decision. Plus, always make sure you’re doing your calculations based on actual current numbers, not projections or the proforma numbers that are sometimes provided by real estate investment brokers – in other words, actual numbers not “what ifs”. You still have to consider the many factors that may affect the potential growth or decline for that specific investment such as the current value of the property or any alternative investment opportunities available on the current market. We folks at 2020 REI and Investable Realty cannot stress enough the importance of performing your thorough due diligence when investing in real estate. It doesn’t matter whether your investing in rent houses, flip houses, commercial properties or SFR Portfolios, completing your due diligence will save you many headaches down the road. This simple practice alone will actually determine the difference between being a true and successful investor or the owner of the next “don’t want it, sell it” kind of deal.