How to Determine A Property’s Cap Rate
Once you have established the kind of commercial property you are going to invest in, it is time to shop for properties. How will you differentiate whether a property is worth it?
Cap rate is a quick method that will help you gauge in what range a property's value will fall under.
CAP RATE = NOI / PURCHASE PRICE
Let's do a quick example:
If you are looking at a property that is priced at $1,750,000 and the NOI is $132,000, this property has a 7.5% cap rate
Now, compare properties of the same size and type. Use online resources to find commercial properties that are similar to the property you are analyzing.
Once you repeat the formula for each of these properties, you can calculate the average cap rate between all the properties.
Let's suppose you are comparing another 2 properties.
Property 1:
NOI - $125,500
Purchase Price - $1,645,000
$125,500 / $1,645,000 = 7.6% CAP RATE
Property 2:
NOI - $137,000
Purchase Price - $1,820,000
$137,000 / $1,820,000 = 7.5% CAP RATE
Now we can add all the cap rates and get the average cap rate:
7.5% (subject property) + 7.6% (property 1) + 7.5% (property 2) = 22.6%
22.6% (total of all cap rates) / 3 (number of properties we are comparing) = 7.5% AVERAGE CAP RATE
Although cap rate is a quick method of calculating property value, it should not be the only factor you look at when determining whether a property is worth putting equity into.
You can use multiple different ways to calculate property value. Make sure that you are connecting with your commercial real estate broker to ask any questions and address any concerns prior to getting under contract for a property you are not sure about.
As professionals, commercial real estate brokers should analyze the numbers of a property beforehand and present you with the right opportunities.
It is your job as a buyer to determine whether a specific property will be the one you inject your equity into.
Do your due-diligence in making sure you order property inspections, appraisals, environmental, and any other third-party reports deemed necessary to make sure that there are no underlying problems in the property you are purchasing.
