Cap Rates for Income Property
How Cap Rates are Used
Cap rate or capitalization rate is the ratio of annual rental income of the property over the purchase price. This number is often shown on commercial property listings and will be in a range of 4%-12%.
The higher the cap rate the higher rental income the property produces and thus the less money you need for down payment. A low cap rate identifies properties with low rental income.
If the cap rate is higher than the mortgage interest rate there is a positive cash flow before expenses.
For example, three listings may show three different cap rates for a property selling for $1 million. The first listing may use NOI (Net Operating Income) of $60K/year ($90K of gross income less $30K of expenses) and thus the net cap rate is 6%. This broker calculates the cap the way it should be. The second listing may use the gross income of $90K and so the gross CAP rate is 9%. The third listing may show pro forma income of $110K to get investors' attention and thus the pro forma CAP rate is 11%!
When making decisions between properties, only compare the net cap rates for a more accurate indication of the property value.
Return on Investment
The returns of a commercial property investment come from four sources: appreciation, cash flow, depreciation, and principal reduction from each mortgage payment. Traditionally, the largest portion of investment return should come from appreciation, but that may not be true in today's market.
There is often a conflict between cap rate and potential for strong appreciation. Properties that offer potential for strong appreciation, e.g. newer properties or ones in good location tend to have lower cap rate. On the other hand, properties that are in poor condition, or have ground lease are much harder to sell.
Unusually High Cap Rates
For difficult properties the seller may try to attract the buyers with a higher cap rate. If you see a property with unusually high cap rate be warned that there is something wrong with the property. The problems can be visible or hidden such as land leases, new competitive buildings being constructed nearby, or a migration of potential lessees from the area.