Understanding Cap Rates

There are many factors investors should take into consideration when evaluating the income potential of a piece of commercial real estate. Cap Rates, also known as capitalization rates, is one-way investors compare the income potential of various properties. While the equation is simple, there are some misunderstandings in the industry as to what is defined as income versus expense. Below we’ve broken down the equation and tried to clear up a few basic misunderstandings.

First – Calculate the yearly gross income of the commercial property. It is important to remember that while rent will be the largest portion of income there may be other revenue sources such as vending machines or other ancillary services.

Second – Subtract the operating costs from the property’s gross revenue. A property’s expenses usually include charges associated with maintenance, insurance, taxes, and property management. The cost of the building or its mortgage is not considered an expense and therefore should not be subtracted from the gross revenue.

Third – Divide the net income by the property’s purchase price. The cap rate is the ratio between the net income of the property and its original price or capital cost. This percentage allows you to quickly evaluate and compare one property’s income potential to another.

Cap Rates can be very useful if an investor is interested in quickly comparing similar investment opportunities. However, they should not be the only tool used to evaluate the risk or return of an investment. Other factors that need to be considered are the growth or decline of the potential income, the increase in value of the property, and any alternative investments available.
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