What Commercial Real Estate Investors Should Know about Cap Rates
By David V. Tran

CAP rate or capitalization rate is the ratio of annual rental income of the property over the purchase price. This number is often shown on commercial property listings. So you must know this jargon if you want to invest in commercial real estate. It’s commonly a number between 3% to 10%.

For those who invest in the stock market, cap rate is the equivalence of the inverse of P/E ratio.  So a cap rate of 5% is equivalent to P/E ratio of 20.  The main difference is in real estate the earning is real while it's accounting earning in the stock market where earning can be reinstated years down the road!

The higher the CAP rate the higher rental income the property produces and thus the less money you need for down payment.  Experienced investors often look at the CAP rate to screen out properties with low rental income. Some investors prefer properties with the cap rate that is higher than the interest rate they pay for the loan. That way they know they collect more from the tenants than they pay the bank.

When the property has high vacancy rate, listing brokers often show proforma (or potential) CAP rate instead to catch investors’ attention.  Let’s use the following example to illustrate the point.  A property is listed for $1M and is 90% leased.  It has gross leases with an actual gross income of $90K/year and $30K of annual expense.  Assuming the proforma income is $110K/year when it’s 100% leased at higher market rent.  So 3 different listing brokers could display 3 different CAP rates for the same property:

•        The first broker may use NOI (Net Operating Income) of $60K/year ($90K of gross income less $30K of expenses) and thus the net CAP rate is 6%.  This broker calculates the cap the way it should be.

•        The second broker may use the gross income of $90K and so the gross CAP rate is 9%.

•        The third broker may want to use the proforma income of $110K to get investors’ attention and thus the proforma CAP rate is 11%!

So as an investor, you need to know what CAP rate, e.g. net, gross or proforma the broker uses.  Otherwise you may offer too much for the property.  At the same time, when you tell your broker to look for properties with a certain CAP rate, make sure the broker knows what CAP rate you have in mind.

The returns of a commercial property investment come from 4 sources: appreciation, cash flow, i.e. cap rate, depreciation (tax writeoffs), and principal reduction from your mortgage payments.  If you invest in the “right” property, the biggest chunk of your investment return should come from appreciation.  There is often a conflict between cap rate and potential for strong appreciation. Properties that offer potential for strong appreciation, e.g. newer properties or ones in good location tend to have lower cap rate. On the other hand, properties that are in poor condition, or have ground lease are much harder to sell.  As a result, seller will try to attract the buyers with a higher cap rate.   If you see a property with unusually high cap rate in California, e.g. more than 7%, you should ask yourself “what’s wrong with this property?”  Chances are you will find a compelling reason why it is so high.

Is the property with highest cap rate the “best” property?  The short answer is no.  If investment was that simple, you would not need an investment advisor.  Cap rate should be one of the various other factors you consider whether you should invest in a property.  It should not be the only factor. Besides, you can improve the cap rate by

•        Increase the occupancy rate.

•        Raise the rent when the current leases expire.

•        Negotiate for leases with annual rent increase.

•        Bring in tenants willing to pay higher rent.

•        Improve the property to attract more upscale tenants.

•        Reduce the expenses not reimbursed by the tenants.

By doing so, you can increase the cap rate and consequently the value of your investment.

David V. Tran is the CEO at eFunding, Inc., a commercial real estate brokerage, commercial loan broker, property management, self-directed IRA investment and syndication company in San Jose, CA.  His website is [http://www.efundingcom.com]http://www.efundingcom.com.  He may be contacted at (408) 288-5500. eFunding does business in all 50 states. © 2007 eFunding, Inc.

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