Everything You Need to Know about Property Crowdfunding

So what is a cap rate?

The Cap Rate (ie Capitalisation Rate or Rate of Return) is a ratio which is widely used by investors to quickly measure whether a commercial property is potentially under or overvalued compared to other similar properties.

Cap rate (Capitalisation rate) % defined

The Cap (Capitalisation) rate % is the net income which a commercial property produces over one year divided by the estimated value of the property. For example, a property valued at $1m which produces net income of $80,000 per year has a Cap rate of 8% (80,000/1,000,000).

Implications of the Cap rate

A low Cap rate may indicate that either the property price or valuation is too high, or that returns from the property are too low.

If the property price is too high, an investor may seek more fairly priced alternatives.

However a low cap rate may also indicate that there is potential to increase returns, for example through replacement / renegotiation of tenant leases or property improvements to lift the lease rentals (for example by improving facilities, presentation or reconfiguration).

A high cap rate of course may indicate the reverse - the property may be undervalued, or conversely returns may be unrealistically high - for example a long standing tenant may be paying rentals which are out of step with the current market. This may point to a high level of risk to future returns.

Advantages and Disadvantages

The advantages of using the Cap Rate measure are;

• quick and straightforward to calculate
• allows an investor to readily compare similar properties from an investment view point
• the Cap rate takes into account property expenses, as it is calculated using net income (ie gross income less expenses)

The disadvantages are;

• the Cap rate does not take into the cost of debt or leverage which the investor may require
• the Cap rate measures performance on a one year historical basis only
• the Cap rate does not take into account the effect of future changes to the property such as improvements or changes in rentals
• it is not appropriate to use the Cap rate to compare dissimilar properties due to structural differences in the nature of tenants and returns

In summary...

The Cap rate is a very useful measure to broadly understand the return from a commercial property, and to compare similar properties at a high level. However, consideration of the Cap rate should not be used in isolation, but should be used as part of a broad, comprehensive review of a potential commercial property investment.

This article originally appeared on the CrowdfundUP blog, the company which I am the founder. CrowdfundUP is a Property Crowdfunding platform that allows investors access intuitional grade property investments all from the comfort of their living room . You can find out more about CrowdfundUP here.

"Any advice provided on this post is general in nature. Readers are urged to seek their own professional advice before making decisions."

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