The Cap Rate
The tool most often employed when evaluating a commercial investment is the capitalization rate, often shortened to “cap rate”. The cap rate is calculated by dividing the net profits of the building by the total cost of purchase. In other words, you divide whatever is left over at the end of the month after paying for all expenses by the total purchase price of the property. For example, the cap rate for a $2,000,000 apartment building that has a net monthly income of $40,000 is ($40,000/$2,000,000) is 2%. The higher the cap rate, the better the investment. However, the cap rate is just one tool to use when evaluating a property and should never be relied on exclusively.
Other Factors to Consider
In a perfect world, the cap rate alone would be enough to evaluate a commercial property. Since we do not live in a perfect world, there are other considerations to account for. The income from a commercial investment stems from monthly rent. Mismanagement can lead a property to receive rents lower than it should. High vacancy rates can also be attributed to poor marketing and overall mismanagement. The wise investor must consider these factors as they could impact the cap rate and belie the potential of a distressed property with a low cap rate as a diamond in the rough.
Ask the following questions:
- Are the current rental and vacancy rates maximized given market conditions?
- Are there relatively cost-effective means of improving the desirability of the property?
- Are neighboring properties garnering substantially more rent or do they possess much lower vacancy rates?
- Is the area going through socio-economic changes (gentrification) that can lead to higher rents in the near future than currently feasible?
These are just some of the many factors to assess when evaluating a commercial property. The importance of experienced representation cannot be overstated. Although anyone can figure out the cap rate, it takes years of knowledge and experience to assess the reliability of that rate.
We Know What to Buy and When
Contact us for a free consultation. If you’re looking to invest in a commercial property our team can provide a list of potential investments and highlight the pros and cons of each property. Likewise, if you’re looking to sell your commercial property, let us provide a free appraisal to help you make the best decision for your portfolio.