One of the most common ways commercial real estate brokers, buyers and sellers value investment properties is by using a capitalization rate or cap rate.
Cap rates show the ratio of income to price for the subject property. In other words, cap rate shows a property’s single-year rate of return.
The formula for to calculate cap rate is simple:
Net Operating Income / Price = Cap Rate
Net Operating Income (NOI) is the income left after expenses like taxes, insurance, and maintenance are paid.
This approach is incredibly simple and is a quick way to see if an investment property is worth pursuing or not. However, if you base your investment solely on cap rate, you may be missing value.
While a cap rate approach may work for single tenant triple net investments, like a Starbucks or Walgreens with a long-term lease, most investment deals aren’t that simple.
Cap rates only calculate a single year of investment - what if you need re-tenant the property in the second year and have to pay for tenant improvements and leasing commissions?
Not all properties are currently exercising their current and best use. Solely looking at the cap rate can decrease the value of the property for sellers and overprice the property for buyers.
It’s important to look for other factors when valuing property, this might include things like:
- the potential to position the property for an alternative use (residential or mixed-use)
- increasing the value of the property by increasing rents and adding amenities
- the impact of increasing efficiency of how the property is managed.