Posted 07-28-2008 1:07 pm by
Understanding the cap rate allows you to figure out how much a piece of commercial property is worth.
Income properties are valued based on how much income they produce, and the cap rate is simply a ratio that tells you how much a property is worth based on the amount of income it generates. The cap rate is defined as the net operating income divided by the sale price. If a property produces $100,000 a year in income, sells for $1 million, the cap rate is $100,000/$1,000,000, which is 10%.
If you look at similar properties that were recently sold in your area, you can compare how much they sold for and how much income they generate. In other words, you can calculate the cap rate for similar properties, and average them to figure out the cap rate for the area. Assuming that the average cap rate for recently sold strip malls in the Eastside is 6%, you can figure out that a strip mall for sale that generates $150,000 in net operating income is worth $2.5 million (simply take $150,000 divided by 6% to arrive at $2.5 million).
If you examine how the cap rate is defined, you will notice that the higher the cap rate, the lower the sale price. Why is that? You can think of cap rate as a measure of risk. An investment with higher risks should give you a higher return, and an investment with lower risks should give you a lower return. A high cap rate means higher risks, and therefore higher return. In order to compensate for the higher risks, you should pay less for the property.
Imagine two strip malls that both generate $100,000 a year in net operating income. One is located in downtown Bellevue (excellent location), and the other is located in Auburn (less desirable location). The Bellevue strip mall should have a cap rate of around 6% (representing lower risks), while the strip mall in Auburn should have a cap rate of 8% (representing higher risks). The Bellevue strip mall is worth $1.67 million (calculated by taking $100,000 / 6%), while the Auburn strip mall is only worth $1.25 million (calculated by taking $100,000 / 8%).
---Written by Oliver Wu
Oliver Wu | Advantage Commercial Brokers
The Commercial Broker for
Small Business Owners in Puget Sound
Direct: (425) 785-6608
Office: (425) 651-4242 ext. 103
Fax: (425) 882-2547
E-mail: oliver@acbrokersinc.com
FREE small business tips at
www.acbrokersinc.com/blog.php
