What is Capitalization Rate (Cap Rate)?
Capitalization Rates (Cap Rates) offer a way to measure the levels of risk that investing in a certain property may bring to any interested parties.
How is a cap rate calculated?
To find out what the cap rate for a building is, the net operating income (NOI)–that is, the annual revenue a property yields minus its operating costs–is divided by the market value or sale price of the property.
For example, if we have an office building with a current market value of $13,000,000, and a NOI of $1,170,000, the cap rate would be 9%.
Is it better to have a high or a low cap rate?
Investors/buyers generally look for higher cap rates, since that usually means they acquired the property for a lower sale price and that the investment will start paying for itself soon. On the flip side, these properties come with higher risk levels.
Landlords/sellers are pushing for lower cap rates because they show the property succeeded in getting a higher sale price. These buildings present lower risk levels, but sometimes the low cap rate might also signal low demand within the market.
For commercial real estate properties, a cap rate of 4-10% per year is considered a reasonable range for investors. However, when trying to establish whether a cap rate is high or low in a specific situation, there are several things one must bear in mind:
– The property type (residential buildings present lower risk levels, so they tend to have lower cap rates, followed by office, industrial, retail, hotel properties)
– Market type (primary, secondary, tertiary) and conditions
– Tenant quality
– Lease expiration date.
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