What is a Cap Rate?

The cap rate (or capitalization rate) is the most important and useful calculation in use in the Raleigh commercial real estate market.  It is very, very important to understand and use cap rates.

The cap rate attempts to measure how much of the gross income is available to pay the mortgage and pay a yield to the investor, after having paid all of the operating expenses.  In other words, the cap rate attempts to measure the future return on investment for a property if it were purchased for cash.

To arrive at a cap rate, you simply divide the income from the property (income after all operating expenses have have been, but before debt service and income taxes) by the sales price:

Net Operating Income / Sales Price = Capitalization Rate

As an example:

If the net operating income for a property is $100,000.00 and the sales price is $1,000,000.00, you divide the $100,000.00 by $1,000,000.00 and the result is 10%.

$100,000.00 / $1,000,000.00 = .10 or 10%

This essentially means that, if an investor pays cash for the property, he can expect a 10% pre-tax return on investment from the income of the property.

Commercial Real Estate Vs. Residential Real Estate

Commercial Real Estate in Raleigh NC, for all but the owner-occupant, is solely an investment and the numbers need to make sense.

Unlike residential real estate markets, which are largely driven by whether or not people like or dislike a home, commercial real estate markets are driven by the profit that can be earned by owning the property.  For this reason, being able to understand the profit potential of commercial property is critical to success.

There are essentially three things that determine the quality of a potential investment:

  • The amount of appreciation expected in the property:  Just like any investment, people who buy commercial property are hoping for the value to increase over time.  Part of what a potential investor will analyze is the amount of appreciation compared to the amount of cash they have to invest to own a property.  This is known as leveraged appreciation.
  • The current, future and/or potential earnings of the property:  Income minus expenses should deliver a net profit.  Investors want to know how much money the property is earning or will earn.  They want to compare this to the value of the property, a comparison that is known as the Capitalization Rate, or Cap Rate.  They also want to compare this to the amount of money they have to invest to own the property.  This is known as the Cash-on-Cash Return.
  • The tax ramifications of owning the property.