- Cap Rate: an Indication of Property Value
- Calculations Example: Office Buildings
- CAP RATE CALCULATOR BASED ON NOI
- Calculating Cap Rate & NOI as a Guide to Office Building Investment
- Want to Know More? Let CXRE Help!
Basics of Cap Rates
First of all, a common way of calculating this return on an investment is by using the Cap Rate (short for capitalization rate, commonly called the Cap Rate or CAP). Defined by Investopedia as “the rate of return on a real estate investment property based on the income that the property is expected to generate,” the Cap Rate estimates an investor’s annual return on their investment. What’s more, Investopedia provides the following formula for calculating Cap Rate, which is typically used for commercial real estate Cap Rate calculations:
Capitalization Rate = Net Operating Income (NOI) / Current Market Value
Firstly, you need to know the Net Operating Income (NOI). In effect, NOI shows investment property’s total positive generated income. Specifically, NOI is what’s you have after paying Operating Expenses (variable costs and fixed costs) from Gross Income. For example, here is a formula:
NOI = Gross Income – Operating Expenses
How to Find Cap Rate with NOI
As stated above, the Cap Rate estimates your annual return on a specific investment (ROI). We mainly use the Cap Rate calculation because it helps determine a real estate investment’s profitability. On a basic level, Cap Rate shows how an asset’s NOI relates to its value.
In the example above, the property’s operating expenses is one of the most important figures for determining Cap Rate. Operating expenses include things like taxes, property management costs, insurance, and maintenance costs. Once you figure out operating expenses, you can then find the Cap Rate.
For instance, if you wish to buy an apartment complex, you need the Cap Rate. Residents pay monthly rent to live on the property. At the same time, as the owner, you’re responsible for the monthly operating expenses. In this example, the NOI is the tenant rents minus the apartment complex’s expenses.
At the end of a certain time period (either the month or year), you need to know how much money remains after paying these expenses. Simply put, this is the most important number to know. You want to know what will the profit after you invest in the property. So we use NOI to find the Cap Rate, a ‘back of the napkin’ calculation for finding an investment property’s profitability.
A Practical Example: Cap Rate NOI Calculator
If you know a property’s NOI, then you can then calculate the Cap Rate from the NOI. In order to clarify this, we offer a practical example below of the Cap Rate formula in action. To explain, if you purchase a building at the Current Market Value of $1M and this investment creates $100,000 of annual NOI, then this formula is true:
$100,000 / $1,000,000 = 0.10 (10%)
In this example, the Cap Rate is 10%. In other words, you pay one-tenth of the property value’s total cost with that year’s NOI.
Cap Rate: an Indication of Property Value
Basically, Cap Rate is the percentage of annual return you could expect to receive on a cash purchase. At the same time, this extremely simple formula doesn’t account for other things. In general, when you compare two or more investment properties, a lower Cap Rate points to higher property values. What’s more, the opposite is also true – higher Cap Rates often indicate lower property values. In order to help you understand this, below are two equations:
Calculations Example: Office Buildings
If the NOI is not published for a certain property, a licensed commercial real estate agent can help you find that information.
Using office buildings as an example, we can help you understand ROI in a more concrete way. For starters, we calculate office building Cap Rates by using the NOI of comparable office properties. Also, we need recent selling prices of comparable commercial properties. Furthermore, when you know the subject property’s income, you can determine more accurately its value.
For example, office buildings in Uptown Galleria submarket, one of Houston’s upscale markets, lease for much more than offices located in nearby office submarkets like the Southwest Freeway.
One caveat to aware of is that NOI’s aren’t always published. At the same time, If you’re unable to find a property’s NOI, then a commercial real estate agent can help you find it. In addition, the agent can also get sales data on comparable properties. On top of that, the local tax office provides sales data for investors like you.
After determining the subject office building’s expenses, you then have a solid comparison between similar properties. In the end, this comparison of properties reveals discrepancies in property costs (either real or perceived). As The Balance says, “When two properties seem just alike and one costs more, it could be because it is generating more income or has lower expenses.”
Is There an Ideal Cap Rate?
Twenty years ago, investors could expect a 10% Cap Rate for commercial investments. However, these days that number is more or less a dream. Since 2002, the average Cap Rate for multifamily properties in both major and minor markets have steadily fallen. For example, in 2002, Cap Rates hovered around 8%. Yet by Q3 2018, rates had declined to around 5%.
Reasons to Use Cap Rate
Without a doubt, there are other ways to value potential investments like the price per unit, Gross rent multiplier (GRM), and the 1% rule. However, Cap Rate is frequently a quick, easy way to estimate value with advantages over other methods. Apart from being widely used metric, in general, Cap Rate:
- includes revenue and expenses
- reflects supply and demand for a certain type of asset in a specific at a given time.
- reflects the asset grade
- may be connected to the debt’s interest rate
Reasons Not to Use Cap Rate
As we’ve seen above, Cap Rate is a simple and useful calculation. Specifically, it lets you quickly size up a commercial real estate property. However, in some scenarios, the Cap Rate isn’t as useful.
For example, if the property’s NOI is either irregular or complex (or both), Cap Rate probably isn’t be the best option. In that case, using a discounted cash flow (DCF) analysis would better account for these complexities and irregularities. So although the Cap Rate gives you a quick ‘back-of-the-napkin’ calculation, it may not represent the property as accurately as other calculations.
Is Cap Rate Different from ROI?
Yes. In general, Cap Rate is useful for comparing properties. On the other hand, ROI (return on investment) is useful for analyzing individual properties. The ROI is the overall rate of return on a property including debt and cash invested.
Unlike Cap Rate, ROI takes the debt on the property into consideration. Specifically, ROI accounts for your out-of-pocket costs (down payment, closing costs, improvements, and other costs of purchasing the property). Overall, 10% is a good ROI for investment properties. Be aware that can seem larger if you mortgage a property. Below is the formula for calculating ROI:
ROI = Annual Return / Total Investment x 100
This formula represents your ROI as a property’s annual cash flow divided by the equity you have in the property.
Imagine you plan to purchase a property for $250,000 and the annual return is $35,000. Using the formula, here’s how to calculate ROI:
$35,000 / $250,000 x 100 = 14%
In this scenario, you would have a 14% ROI on your investment property making it a solid investment. At the same time, if you’re searching for the highest return, it is beneficial to also consider the ROI of other nearby properties.
CAP RATE CALCULATOR BASED ON NOI
Updated for 2019: Whenever an investor is looking to purchase a commercial property, they want to know its potential income. Regardless of whether it’s an office space, commercial retail space, or an apartment complex, having a solid idea about the investment’s return is crucial. Futhermore, this is especially true when comparing similar properties. As a result, we’ve updated this ‘Calculate the Cap Rate’ page for 2019. Moreover, we’d added the above calculator for commercial real estate investors like you to use.
A Word of Caution
Without a doubt, Cap Rate is a tried-and-true approach for finding the value of a commercial real estate investment. Yet, as a real estate investor, you should take the following word of caution with a grain of salt: When using Cap Rates, it is wise to use them alongside other valuation methods.
When determining the quality of your next investment, it is a good idea to consider at least one other valuation approach. You could use a Market Comparison, Gross Rent Multiplier, or even Value Per Door alongside Cap Rate to give yourself a better, more accurate valuation of a property that you’re buying or selling.
Calculating Cap Rate & NOI as a Guide to Office Building Investment
In conclusion, determining the value of an office building for investment purposes might seem complicated. By calculating the Cap Rate and NOI, you can obtain a fairly accurate value.
Want to Know More? Let CXRE Help!
If you still have questions about Cap Rate and want to know more, contact one of CXRE’s commercial real estate experts today. We’d be happy to help you understand so that you can maximize your investment potential.
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