As a commercial real estate owner, you likely care about your return on investment. But how do you know if your purchase will bring the profits that match your goals? A cap rate is a metric often used to understand whether or not prospective investments are “good deals.” With that said, let’s dive into what cap rates are in commercial property.
What is a Cap Rate?
The capitalization, or cap rate, is a percentage used to estimate the profitability of a property. It uses the following formula:
Cap Rate = Net Operating Income (NOI) ÷ Current Market Value of Property
You can find the NOI by deducting your expenses from the annual income generated. Your income can include rent collected, parking lot revenue, vending machines, and other amenities. The expenditures you subtract include the following:
- Building maintenance
- Property management
- Property tax
- Insurance
- Utilities
- Other operating costs
Keep in mind that we don’t deduct the costs of buying, selling, or financing (i.e., a loan or mortgage).
Why are Cap Rates used for Commercial Real Estate Property?
This formula produces a valuable metric in commercial real estate that can help you compare properties and understand how much profit to anticipate. The higher the percentage, the more return you can expect.
This number also indicates the perceived risk. There’s more to worry about with higher cap rates because it reflects less property value and factors like poor building conditions, low-traffic locations, or tenants defaulting on their lease payments.
A lower cap rate means smaller returns on investment and less perceived risk. These buildings have more expensive purchase prices, and you can often find these in affluent, high-traffic areas where tenants provide stable sources of income.
What is a Healthy Cap Rate for a Commercial Property?
A reasonable cap rate depends on many factors, like the building type and location and your investment strategy, risk tolerance, and desired return. The rule of thumb is that your cap rate should be more than the cost of financing. For example, if you have a 4% mortgage, a cap rate above this would be profitable. Generally, 4% to 12% is fair, but let’s put this into more context.
Suppose you’re an investor who wants a return of 11%. Remember that this might come with more physical, operational, or location risks. If you can tolerate this, a cap rate of 6% may be inadequate because it’s less than your desired return.
Alternatively, if you want more stability, you’re required annual return might be 5%. You may consider this same cap rate of 6% perfect for your goals.
The Benefit of Selling Your Commercial Property Based on Cap Rates
You can use your cap rate as leverage in the seller’s market. Lower percentages attract buyers because this predicts a stable investment. They are also good for you as a seller because your property has high value.
You can also use this metric as a benchmark for future goals. For example, if you bought your commercial real estate at a higher cap rate to repair and upgrade, your exit cap rate at the time of selling may fall, which means more money in your pocket.
While cap rates are a valuable indicator of your investment, it’s crucial to do your due diligence for a more comprehensive understanding. At Zinati Realty, we are leaders in the Ottawa commercial real estate market and have the expertise to guide you through all the factors determining sound buying and selling decisions. Contact us today to learn more.