What Makes a Good Commercial Real Estate Investment?-Part 2
In my last post we discussed the different type of real estate investors and what it takes to start investing in commercial real estate. In this post we will look at the most basic tool used in analyzing a commercial real investment - the CAP rate (short for capitalization rate).
The CAP rate is
used by investors and appraisers to compare real estate investment properties. The CAP rate is a good snapshot of the first operational year to determine if the price or value is in line with the income of similar properties, but it doesn't tell the whole story. It compares the annual income (after vacancy and operating expenses - not including financing) called net operating income (NOI) to the sales price. It doesn't necessarily mean the percentage return on the investment, but it gets close provided there is no financing.
The CAP rate is calculated by dividing the NOI by the price or value, expressed as a percentage. Not only is it a quick snapshot when an investor compares properties, but lenders tend to focus on the CAP rate used in the appraisal.
I met with an investor group who purchased a property for $4.25M in 2007. The advertised CAP rate by the developer was 5.8%, which was aggressive for this location and type of tenants even for the height of the real estate market at the time. If you multiply the price by the CAP rate you will find what the income was supposed to be. Unfortunately, the income projections did not come through and the economy tanked. Their investment is now worth less than $1.5M and the CAP rate is over 10%, plus their loan balance is $2M...ouch! This transaction will result in a short sale and a loss to the investors. An experienced commercial broker on your side is important when purchasing investment real estate.
Here is a good rule-of-thumb with the CAP rate: If an investment has great tenants, long leases, limited responsibility of the landlord and a new building with market rent, an investor is willing to take a
CAP rate. Whereas, if the tenants are unstable, the property is in a dieing area, the property needs maintenance and upgrades and the rents are low, an investor is exposed to more risk and desires a
CAP rate. Being that rent is unchanged in the CAP rate snapshot a great investment property would allow for a higher price and a not so good property, a lower price.
I will leave you with an example of a good deal. I have a client who is considering selling his property in Napa. He has a multi-tenant neighborhood strip center. His annual gross rental income is $108,424. Annual operating expenses are $29,237, which gives him an annual NOI of $79,187. CAP rates for his type of property is 8%, this roughly gives him a value of $990,000. Being that he is considering placing the property on the market for $1M it should gain lots of interest.
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