One of the most important formulas in the commercial loan world is capitalization rate, or cap rate, of a property. This is a way you can compare one income producing commercial property to other similar properties. It is also a way that allows a commercial lender or buyer of a property to value a property based on its income.
The ability to calculate capitalization rate of a building gives you one additional way in which to value a commercial property. By being able to calculate this figure, someone looking to purchase a property has a tool with which to ballpark value of a property. It also allows a lender making commercial loans to make sure the value of a property and subsequent loan to value fits their guidelines without investing too much time. This calculation does not replace a full appraisal, but is a good time saving tool to use to find a quick estimate of value. Using the cap rate values a property based on the income, and could indicate a different value than recent sales comps might suggest.
Cap rate in a nutshell is the annual return on a property if there was no debt service (no loan). The cap rate is taken by dividing the net operating income by the estimated value of the property. A higher cap rate suggests a better buy on the property.
When you do these calculations, it is very important to be working with accurate numbers. Your end result is only as good and accurate as the input. A small difference in your cap rate can turn into large valuation differences. Much larger than you may think. The best way to explain this is to look at some actual numbers.
For our first example, we are going to look at a property that has a net operating income of $200,000. If our property value were $2,500,000, then the cap rate of our property would be 8%. Our calculation would look like this:
Cap rate = 200,000/2,500,000
Cap rate = 8%
The formula for this is:
Cap rate = NOI/FMV, where NOI is net operating income and FMV is fair market value.
Another way to utilize cap rate is in estimating the value of a commercial property. For commercial loans, this is a quick way to evaluate a particular transaction. We use the same formula, but instead of calculating for cap rate, we will figure for value. By contacting local realtors, let’s say we find out that properties in the area of the same type are selling for an average cap rate of 10%. If we use $200,000 as net operating income, we can use the cap rate and NOI to figure a value for the subject:
200,000/10% = 200,000/.10 = $2,000,000
So our implied value on this property using a 10 cap rate is $2,000,000. Play around with the numbers on this one, try figuring value at an 8% cap rate, you will find that a 2% change in cap rate on this one will equate to a $500,000 difference in estimated value!
The formula we used for this example is the same as in our first, we just calculated for value instead of cap rate. The formula for this calculation is:
FMV = NOI/Cap rate
Hopefully this has shed some light on how a cap rate calculation can be important not just for commercial loans, but also for evaluating your commercial real estate purchase. It is not a hard calculation, and once you are clear on how it works, it can be a great tool to have!