When considering whether to purchase commercial real estate, every savvy investor will question whether a specific deal is really a “good deal” or not. And by a good deal, they usually mean, “what is the return I will receive on my money?”
The best way to understand if an investment property will be a good investment is to compare it to other investments. If someone had $250,000 to invest, for example, they’d want to look at many different investment vehicles (stocks, bonds, commercial real estate, and more) and consider the return on each, and how long of a hold would be needed for their capital.
Let’s say an investor decides to invest $250,000 in commercial real estate. Maybe they feel this property will have the best return based on the current state of the economy or given the specific market in which they’re looking to invest. Or maybe they want to invest in commercial real estate to diversify their holdings. In either case, the investor now must compare properties to understand which is the most lucrative investment opportunity.
A good metric to initially qualify commercial real estate properties is by looking at the property’s capitalization rate, or “cap rate”. People discuss cap rates frequently in the commercial real estate industry, but most people don’t look at the spectrum of a cap rate. Do calculate the capitalization rate, take the net operating income (NOI) and divide it by the purchase price of the real estate investment. A quick example: a 1 million dollar building that throws off 100,000 in NOI annually is a 10 cap.
100,000 / 1,000,000 is .10 or 10%
What is a Good Cap Rate?
This really depends on what investment you’re looking at. A “good cap rate” is subjective based on the property type and asset class. Sometimes a lower cap rate may be desired because the asset will prove to be more stable. The novice investor focuses on the net operating income (NOI) and cash flow upon purchase and therefore will like a higher cap rate. The savvy investor knows that capitalization rates have become synonymous with risk more than anything else. In order to determine a good cap rate for rental properties like a multifamily apartment building, retail center or other investment property, you need to understand how much risk you are comfortable exposing yourself to.
Different cap rates will give you an idea of how much risk can be expected. Low cap rates for lower risk, higher cap rates for higher risk. The question should really be “what’s a good cap rate based on my risk tolerance?”
If you need an answer to the original question “what is a good cap rate:” a cap rate that falls between 4 and 12 percent is typical and considered to be a good cap rate. This will depend on the type of investment, asset class, and the location of the investment property.
Cap Rate Impacts
Every property is different, and your cap rate can easily be affected. Make sure you are looking at the complete picture of the investment even after you have calculated the cap rate.
Asset Type And Class
What kind of property are you investing in? A commercial property would likely warrant a much larger cap rate because if the economy pulls way back you could be sitting on a huge mortgage payment without any tenants to cover it. Make sure you understand the health and credit of the tenant in the property you are purchasing. Real estate investors should understand the asset class as well as a potential investment property. A class a property will generally have a lower cap rate due to higher stability whereas a class c property will likely have a higher cap rate due to the larger risk profile associated with the larger potential return on investment that come with a high cap rate.
Location, location, location. Should this property become vacant, how quickly will it re-rent? Vacancy will surely affect you rate of return (ROI) and in turn, your cap rate. The property value and market value of an asset will be different in each market. Based on your location, real estate investing overall for some assets will have a higher or lower cap rate calculation.
What kind of rental is this and how are you planning on maximizing its potential? You’ll need to focus on your operating expenses and the areas where your net income will be coming from. If you have a strategy that will easily increase your NOI and is achievable, this investment strategy will help you to force the appreciation and therefore increase the cap rate.
Supply and Demand
Is your investment in high demand, or is it a dime a dozen? If there are several investments like yours in the area. Can you remain competitive and still achieve the cap rate you’re looking for? Don’t get into an investment only to find that you need to drop your prices once you’re in there
Interested in Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets – well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our retail investment opportunities, contact us at (800) 605-4966 or send us an email at email@example.com for more information.
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