The Cap Rate ( Capitalization 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 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).
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.
We have discussed the advantages and disadvantages of capitalization rate to understand below.
This 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 how CrowdfundUP works.
The information in this article is general in nature. Any advice it contains is general advice only and has been prepared without taking into account the objectives, financial situation or needs of any particular person.
The article content is not intended to be a substitute for professional advice and readers are urged to seek their own appropriate advice before making decisions.
Any reference to a particular investment is not a recommendation to buy, sell or hold the investment.