Capitalization Rate (Cap Rate)

I get quite a few questions asking me, "How much is a commercial income property worth?" and "How much can my clients afford to pay for this property?"

One tool everyone has heard about but not everyone fully understands is Capitalization Rate or CAP Rate.

The formula for Cap Rate is Net Operating Income (NOI) divided by Purchase Price= CAP Rate.

To get a valid CAP Rate an agent needs to be able to verify the Net Operating Income (NOI) for the business.

Example:  You have a business owner that wants to list for $1,500,000; he is able to furnish you with adequate numbers from his QuickBooks program or better yet from his three most recent tax returns showing the Income and Expenses for his company.

His net operating income over the past three years has averaged $120,000.  If you do the math his CAP Rate will be 8%.  $120,000 divided by $1,500,000 equals 8%.

What does this mean to a potential Buyer/Investor?

It means if the numbers are correct he can expect to get an 8% return on his investment during his first year of ownership if he pays cash for the business.

The first question the investor will ask is to see the numbers and how the NOI was generated.

Gross Income-Operating Expenses=NOI.  These numbers do not reflect debt service, interest costs or depreciation.  In this calculation we are looking at the numbers from a cash only standpoint so Interest, Depreciation and Bank Loan Payments are added back to reflect a cash position.

One needs to review the numbers in detail and see if there are any annual expenses that can be added back to increase the NOI.  Such things as management fees, owner auto expenses and employee salaries that could be replaced by new ownership taking over these duties need to be reviewed and factored into the adjusted NOI.

Finally, as an agent you need to take a good look for deferred maintenance.  Is the roof in good shape?  Is the HVAC system fully functional?  Is the equipment needed to run the business up to date or does some of it need to be replaced at the time of purchase or within the first three to five years?  A good commercial building inspector will be able to provide you with much of this information but if there is a specialized equipment as part of the transaction you may need to bring in an expert to give you an opinion of value.

Commercial real estate is an exciting business and you can never know too much.  May all your transactions be good ones.