A commercial building in New England

What Is A “CAP” Rate?

What separates residential property value from commercial is the economic performance. Residential has none, and commercial has nothing but. As investments, residential property is pretty lousy – no offense to readers who are homeowners – I am one too. But, look at your home purchase and its ROI (return on investment) after 10 years. I will bet its capital appreciation is somewhat if not largely offset by the expense of keeping the place up, which has no income to offset. We should just be glad it’s not a car that loses value faster than a summer day loses heat.

Enter the “CAP” rate, which is short for capitalization rate. This metric, expressed as a percentage, gives a buyer important information about the economic value of a property, namely how fast will the purchase price be recovered by the NOI (net operating income)? The NOI is gross rents less insurance, taxes, and maintenance, which may include property management fees and capital fund contributions (for major capital replacements like a new roof, heating system, or parking lot). Financing and depreciation are not part of the calculus.

For example, a $1,000,000 income property that has an NOI of $100,000, has a CAP rate of 10%.

A $900,000 property with the same NOI has a cap rate of 11.1% ($100,000/$900,000). When you know the price and NOI you can always determine the CAP rate. And, knowing the income and CAP rate, you can derive the price; know the price and CAP rate and you will know the income.  So, this tool is vital in quickly determining whether an investment is worth investigating.

Not all CAP rates are equal. An “anchor” store, let’s say a Walmart in a prime location, may have a CAP rate of 3%. This is an indication that the building is stabilized by a long lease with an international corporate behemoth. That level of stability and location drive up the price, pushing down the CAP rate. Buyers will pay a hefty premium for commercially vibrant locations and long leases with anchor tenants.  Conversely, CAP rates of 15% or higher may be common in depressed areas or poor locations where the stability of tenancy is weak.

In the Maine market, the range of CAP rates fluctuates too, from 7% to 14%. Once an area, town, or neighborhood is selected to look for commercial opportunities, finding out what the prevailing CAP rates are in the area is essential in gauging the viability of a particular investment. 

I have seen investment properties grossly overpriced because they are in desirable residential neighborhoods, close to the beach with water views, etc. Residential agents who don’t understand this important metric to determine value will miss the mark. Investor/buyers will simply not consider a 3 CAP where the property begins to be viable only at a 10 CAP, regardless of the proximity to a residential perk.

So, using the CAP rate is an excellent starting point to find a good commercial opportunity. Of course, the devil is in the details. CAP rates can be fudged to mislead buyers into thinking the property is earning more net dollars than it really is. Due diligence on this is the first step to understanding whether or not a property is worth pursuing.

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