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Investors in commercial real estate – folks who rely upon the rent paid by a tenant for their livelihood – use a number of different measures in analyzing their investment.
The most common metric is a capitalization rate or cap rate. Simply stated, a cap rate is the quotient of the yearly net operating income divided by the purchase price.
If a building sports an annual net operating income – the rent minus the expenses – of $100,000 and the building is worth $2,000,000 – the resulting cap rate is 5%. Easy enough.
As you can determine from our example – if the net operating income increases – say to $120,000 – and the purchase price stays static – the cap rate also increases to 6%. However, if the net income stays the same – the purchase price decline to increase the cap rate. Therefore the value and cap rate are inverse of one another – akin to a stock dividend.
Ok. So what? Do cap rates matter? Sure, they do. But only when taken in context and in combination with other criteria such as the cost per square foot of the building, the relationship of the current rents to market rents, the viability of the tenant, the sustainability of the income, and the trends in value. In other words – a cap rate is a still photo. When combined with the features above – it cocoons into a panoramic video.
Cost per square foot. If a parcel of commercial real estate is purchased below the cost to build it – replacement cost – generally a market rent will return a market cap rate. Trouble brews when the cost per square foot far exceeds the cost to produce.
Current vs market rents. Recall, our cap rate is the quotient of the net income divided by the purchase price. But if the rents are well above the current market rents – a distortion in the cap rate occurs.
Viability of the tenant. Market rents, great cap rate, decent price per square foot are all for naught if the tenant defaults. The costs to originate a new lease – downtime carry, abated rent, tenant improvements, broker commissions – are staggering.
Sustainability of the Income. A viable tenant with a multi-year lease spells an income stream that is sustainable.
Value trends. You’re comfortable with the rents and their relationship to the market. But are the rent trends up or down trending? You don’t want to get stuck with an overmarket rent come renewal time lest you must reduce your return.