Let’s kick off by acknowledging the unavoidable fact that commercial real estate investing is both complex and requires an in-depth knowledge base before you can navigate it smartly.
Although this article will provide insight to two effective instruments for evaluating a good investment, it must be expressed that there are many other approaches that should also be considered. However, and to keep things light, if buyers/investors can understand essential financial metrics like “cap rates” and “cash-on-cash” returns, they will be far better at making informed decisions. Whether you’re a seasoned investor or just entering the market, these two metrics should always be utilized when establishing the profitability and potential of a commercial property.
Cap rates
A “cap rate” is an abbreviation of the term “capitalization rate” and it is a fundamental tool used by investors and brokers to evaluate the profitability of an income-producing property. Just note that if a property is not generating income (rent) then this approach can not be applied or would yield a 0% cap rate. That said, the cap rate represents the rate of return, or ROR, for a property based on it’s income relative to it’s purchase price.
Fortunately, it’s very simple to calculate and most folks with a calculator can perform this task quickly. Simply divide the property’s net operating income, or NOI, by its current market value or purchase price. As a quick example: If a property generates $100,000 in NOI annually and is valued at $1 million, the cap rate would be 10% ($100,000 / $1,000,000).
OK, great! We have a 10% cap rate! Is that good? That depends on the investor’s risk tolerance. As an unofficial guide, a lower cap rate (1%-6%) tends to mean the property is more secure (long-term lease, corporate-backed tenant, etc.) whereas a higher cap rate (7% or more) indicates that there is typically more inherent risk (history of high lease turnovers, unsecure tenants, slow rents, etc.). Investors should have established risk tolerances before applying an appropriate cap rate to commercial real estate property evaluations.
The role of cap rates:
- Risk assessment: Higher cap rates typically indicate higher risk, such as properties in less desirable locations or those requiring significant management.
- Market comparison: Investors use cap rates to compare similar properties on the market.
- Valuation tool: Cap rates can also be used to estimate the value of a property based on its income potential. If you rearrange the cap rate equation, investors can better determine the maximum price they should/would pay for a property to achieve their desired return.
Cash-on-cash evaluation
Understanding how cap rates provide a snapshot of a property’s income relative to its value, it is also wise to implore a “cash-on-cash” evaluation. Cash-on-cash dives deeper into the actual cash flow an investor receives versus their initial investment. This calculation method focuses on the cash income generated by the commercial property compared to the investor’s initial cash investment. To calculate a cash-on-cash return, grab your calculator and divide the property’s pre-tax cash flow (the net operating income without the debt service) by the initial cash investment (the down payment and closing costs).
As an example, if an investor puts down $100,000 in cash and the property generates $10,000 in annual cash flow after expenses and mortgage payments, then the cash-on-cash return would be 10% ($10,000 / $100,000)! On paper, a 10% return on investment would be appealing to most folks, but just like the cap rate approach, it is only a piece of the overall puzzle when evaluating a property’s profitability for investors.
Value assessment: Cash-on-cash offers a clearer path for understanding a property’s profitability.
Valuation tool: Investors often use cash-on-cash returns to evaluate different financing options and/or to compare the profitability of real estate investments with other assets.
Commercial real estate brokers should be well-versed in guiding investors through the complexities of cap rates and cash-on-cash evaluations. These methods are key insights with analyzing properties, and investors should be ready to ask their broker for these evaluations when discussing investments.
In the world of commercial real estate investment, understanding cap rates and cash-on-cash returns is arguably indispensable. In a perfect world, a knowledgeable broker-and-investor combo should be able to navigate the waters of commercial real estate investing shrewdly if they are well-versed in these evaluation metrics.
Cap rates and cash-on-cash approaches cannot be solely depended upon to evaluate an investment, but in the many years of aiding buyers/investors, I’ve personally never seen them not both used prior to an acquisition.
If none of this makes sense, it’s OK. That is why we encourage all who want to invest in property to consult an experienced broker about these matters. Knowing these methods exist is half the battle!
Vincent A. Campana III is an associate broker at Campana Waltz Commercial Real Estate West. For more info, visit cwcrew.net.
*Correction: A correction was made on July 22, 2024. Due to an editing error, the website to get more information was listed with the incorrect link. The correct website is cwcrew.net.
