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Making an investment in commercial property? Understand the capitalization rate.

At Allied Realty Group, we understand that all asset classes experience market turbulence and fluctuations in value.  Each segment of the real estate market will at some point be impacted by various economic conditions and cycles.  If you are looking to dabble in the commercial real estate market as an investment, you need to understand what a capitalization rate is.  The “cap-rate” as it is commonly named, is the ratio between the net operating income(NOI)  produced by a real estate asset and the price you paid to acquire that asset (Price).  It can be calculated by dividing the NOI by the price.  You may apply this tool in order to analyze the investment value of multi-family, industrial and office properties.   Years ago when the commercial real estate market was booming, most people figured that cap rates didn’t matter.  Those are the same people that found out that just like the P/E ratio matters to stock investing, the Cap rate matters to property investing.  In a snapshot, it is as simple as this:

  1.  Input the purchase price of the property you are looking at.
  2. Calculate the total annual rent for all of the units in the building, which is called the Potential Gross Income (PGI).
  3. Subtract 5.00% of the PGI for your Vacancy and Collections Loss and you now have the Effective Gross Income number (EGI).
  4. Now list your annual operating expenses for the property, which include the following:
  • Real  Estate taxes
  • Any Miscellaneous Fees
  • Insurance
  • Electric, Utilities , Water and Trash Expense
  • Repairs and Maintenance (Typically 5.00% of EGI)
  • Reserve for Replacement (Usually 2.00% of EGI for larger building repairs)
  • Any Miscellaneous Expenses
  • Management – Usually between 5-10% of EGI, even if you plan to manage it yourself, there is still a value placed on your time.

Now, subtract your total operating expenses from the EGI to obtain the NOI figure. Divide the NOI / Price and you will now have the capitalization rate for the property. If you would like to see your annual net income figure, just subtract the annual cost of your debt service on the property and what’s left over is the Annual Net Income figure.

Keep in mind that the lower the cap rate, the lower your investment return is on the property.  With that being said, a 10 CAP is much more attractive than a 6 CAP.  Some of the prime, class “A” properties trade at a lower cap rate due to the higher quality.  As an owner or prospective owner of real estate assets, you need to need to understand the fundamental analysis that drives market pricing. Regardless of any current market turbulence, Allied Realty Group will provide sound advice and help you formulate a long- term real estate investment plan. Call us at 954-586-8400 or send us an email at [email protected]  today, we look forward to working with you!