When investing in commercial real estate, it’s important to note that assessing property value involves more than just looking at comparable sales and market data. One of the main factors used to assess commercial property is capitalization (cap) rates. Cap rates can seem confusing and complicated, but their purpose is simply to account for the income-production potential of commercial real estate. A better understanding of cap rates can help you to better assess potential commercial properties before investing in them.

The first thing to note about cap rates is that they are inversely proportional to the value of the asset. Therefore, if a cap rate increases, the value must decrease. And, conversely, when asset prices go up, the cap rate goes down. This is because the cap rate is calculated by dividing the Net Operating Income (NOI) by the market value or purchase price of the property. Thus, if an investor purchases a $1 million commercial property with an NOI of $50,000, then the cap rate of the property is 5%. If the investor was able to get the property for only $850,000, then the cap rate would increase to 5.88%.

So what goes into calculating the NOI for a commercial property? NOI is the income produced by a property above and beyond the operating costs of the property. Income can come from a variety of sources such as rents, common charges, and parking fees, and the operating costs can include payments for utilities, improvements, maintenance, taxes, and insurance. The costs of carrying vacancies can also impact the NOI. Another way to improve the cap rate of a property is to lower the operating costs and increase the NOI. In the previous example, if the NOI increases to $58,800, then even with the original valuation of $1 million, the investor can still get a 5.88% cap rate.

Investors often ask lenders what a good cap rate is, but there isn’t one simple answer for this as the cap rate is influenced by many factors—everything from geographic location to interest rates to the perceived risk of the investment. Location influences cap rates as when asset prices and demand are steady, cap rates are likely to be lower, whereas when prices are declining and demand is lower, investors expect higher cap rates. This not only adjusts for demand, it also compensates investors for the higher risk of investing in a rural or declining market as opposed to safer and more stable investments in metropolitan markets. In this way, a cap rate can be used not only as an indicator of the return on investment that an income-producing property promises, but also as an indicator of the risk associated with the investment. 

If you need a private capital loan to help you purchase an income-producing property, contact Montegra at loans@montegra.com or 303-377-4181 for more information about our loan programs.