How to use a cap rate for commercial property investment
Whether you’re a first-time commercial property investor or an expert in the game, the capitalisation (cap) rate is a tool you may need to use.
This is a handy industry standard calculation which is used across all real estate to determine the potential return on investment (ROI) of a property and how this compares to similar premises. In commercial property, it’s vital in helping investors make the best purchase decisions.
What is the cap rate formula?
Finding the cap rate is a simple equation – the net operating income (NOI) of the property divided by its current market value and/or purchase price.
The NOI is a true net figure that is the property’s return on investment minus the costs required for running the property, such as building maintenance, insurance, all statutory rates and taxes, and property management services. These expenses and break down of operating costs can be found through the Vendor’s / Owners cash flow expense statements. It’s important to look at the last financial year’s statement as well as the budgeted statement of outgoings for the current financial year.
How can it be used?
The cap rate has many advantages to you as an investor, especially during the buying process.
Before you even enter into conversations with the Vendor, the cap rate will immediately reveal if the asking price is fair and worth your time and effort. If you’re still interested in the property, the cap rate is useful in identifying the level of risk involved and will allow you to decide whether you have the risk tolerance for it, or if you will be able to manage and minimise those risks in the future. It also gives you the upper hand in negotiations by providing you with a sound argument when asking for a reduced price.
However, if you’re a business owner looking to lease a commercial property, the cap rate is of little use, as your focuses won’t necessarily be on capital growth and the NOI of the premises.
Tracking market trends
Even if you’re not currently looking for commercial real estate, tracking the cap rates of different asset classes over a prolonged time period will allow you to identify the best opportunities and purchase time. For example, increasing cap rates indicate a slowing market and a good time to buy, while you may want to hold off on sectors which are experiencing a tightening of cap rates.
You don’t want to sit on decisions for too long and risk missing out on an opportunity. Fortunately, the cap rate is one method which can allow you to assess quickly your level of interest in an investment. With the cap rate, you can quickly compare similar properties and grasp the strengths, weaknesses and risks of your selected property.
How do I know the level of risk involved in a property?
The higher the cap rate, the greater the risks involved. But again, this isn’t necessarily a bad thing – it all depends on your personal risk preference and capabilities, and the type of asset class and location of your property.
What are its limitations?
While the cap rate is extremely useful, it also has its pitfalls and shouldn’t be used in isolation from other assessments and metrics.
In fact, the number one trap commercial property investors fall into is relying too heavily on the cap rate when estimating the potential value of a property and misusing it. An example of this occurring is when a high cap rate is found because of the current tenant’s lease. In theory, while the cap rate might identify an upcoming lease expiry as a major risk, the tenants may be looking to renew, or you could have strong connections to potential future tenants. If this is the case, this could create a good “value-add” opportunity through letting up.
Especially in commercial real estate, it’s less likely that multiple similar properties will be found in the exact same area. Therefore, you may need to explore surrounding areas, which will bring in differing features and variables that affect the property comparisons. Usable comparable sales must also be within the last 12 months, as they will become irrelevant after this time. Depending on the state of the market, you may also need to look at sales within a shorter time period if it’s a moving market e.g. the last 6 months.
The cap rate also assumes that your revenue estimates are 100% accurate and that the market value is permanent. But all commercial property investors will know that the market value is constantly fluctuating. It also doesn’t consider that future revenue can be impacted by property improvements, annual increases in rent and more.
Finally, the cap rate needs to be recent and frequently updated to reflect the current state of the market.
Where to seek help
Reach out to an experienced property advisor who will help you understand and utilise the cap rate in your commercial property decision making.
Contact us to discuss your needs. No obligations.
Managing Director, Broadway Property
Director, Broadway Property