Understanding Capitalization (CAP) Rates

Understanding Capitalization (CAP) Rates

ratesblogCommercial real estate properties include:

  • Investment (tenant occupied) properties
  • Owner occupied properties

Most commercial real estate properties are for investment, and therefore the decision by an investor to purchase a commercial property is primarily based upon a financial performance analysis of the asset. One of the fundamental components of the financial analysis is the Capitalization (CAP) Rate.

What is the CAP Rate?

The CAP Rate is calculated as follows:

CAP Rate = NOI/Price, where NOI is the Net Operating Income of the asset and Price is the price of the property. The CAP Rate is analogous to a simple Rate of Return (ROR) calculation for an investment. For example, if you invest $100,000 into a CD (Certificate of Deposit) and your annual return is $10,000, then your ROR = $10,000/$100,000 = 10%.

Similarly, if an investor purchases a commercial property for $1,000,000 and the Net Operating Income is $70,000, then the CAP Rate = $70,000/$1,000,000 = 7%.

Of course, the commercial property’s Net Operating Income (NOI) is needed for the CAP Rate calculation. The NOI is determined from the asset’s gross income and expenses. An investor (buyer) typically obtains the necessary financial information by requesting it from the seller or the seller’s agent prior to executing a commercial real estate sales transaction.

It is customary that the sale transaction purchase contract sets forth the details by which the buyer and his agent verifies or determines a CAP Rate and other important components of his financial analysis by his own due diligence work while in escrow.