![]() If there is a four tenant building generating $100K in annual rent and two tenants move out, the annual rent collection could drop to $50K (in the absence of a good Broker). Real estate comes with inherent risks and several other factors can lower the cap rate. If the tenant is a highly accredited national chain with a low chance of default, investors are willing to accept returns on the asset value as low as 5%. If there is a single mom and pop shop renting the building without a substantial personal guarantee, investors will want to get a higher return on the asset value, usually upwards of 10%. The riskier the investment, the higher the return investors will want to see. The cap rate can be compared to riskiness. ![]() Some banks lend 80% of the purchase price while others lend only 60%, and some investors will choose to purchase completely in cash. The cap rate is a better measure of value compared to ROI because the ROI is determined by the debt service, which can vary widely. This means if the investor bought the building in cash, he could expect his return on investment to be 10% which is the same as a 10% cap rate. The NOI of $100,000 divided by the building cost of $1 million is 10%. The property has $20,000 in maintenance expenses and taxes, leaving $100,000 in NOI. If the building was inherited for example, there is no building cost, so using the current asset value divided into the NOI will yield the most accurate cap rate.Īssume a building has an annual rent collection of $120,000/year. The asset market value can be used in place of the cost of the building in determining the cap rate, if the building is not for sale. This includes things like lawn maintenance and taxes, but not debt service. The NOI is the annual income expected from rent minus the expenses for managing the property. It allows you to compare different buildings at a glance and quickly determine how the asking price is valued based on the rent. The cap rate is a great unifying metric because it assumes the property is purchased in cash and not a loan, which can vary widely. Commercial Brokers frequently use this term in connection with the sale of investment real estate.Ĭapitalization rate = Net operating income / Cost of the building ![]() It’s calculated by taking the net operating income, NOI, and dividing it by the cost of the building in order to give the rate of return (the term “return” may not be appropriate in all scenarios such as a building that is 100% financed). A cap rate (capitalization rate) is a term in commercial real estate that refers to the way a building is evaluated.
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