The cap rate, also known as the Capitalization Rate, is the ratio of Net Operating Income (NOI) to the property asset value, and is a great metric to determine property values relative to other similar commercial properties. The use of a cap rate as a comparison method is especially useful in multi-family and other leasing properties.

If the purpose is to evaluate the profitability of a potent commercial real estate purchase, finding the cap rate will quickly show which properties have the most future income potential (higher cap rate), or are in more financial stable areas of rising real estate values.

Cap Rates Allow Easier Comparison of Properties

If you are concerned about the return on cash flow, cap rate comparison allows your agent to look at other income producing properties that may represent a good investment. This could be comparing an apartment building with a small strip mall. Both of these properties are commercial income properties that will make money, but which one has a better investment value?

By using the cap rate formula (taking the Net Operating Income and dividing by the property value) the number will represent a percent or a ratio of comparison.

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Cap Rate Lets You Survey the Risks of Different Areas

In some areas, for example by the ocean or other desirable neighborhoods, the cap rate will be higher. The properties may appreciate faster than the effective rents, making a small ratio number of less than 5% or lower. A high cap rate of more than 9% means the property produces 10% or more of its value in annual income for the investor. These types of properties may be located in an area that has higher risks for the investor, such as foreclosures or many rental or commercial vacancies.

Commercial properties in remote areas can look like an excellent investment on paper due to the low purchase price, but when considering the effort required to bring a long term tenant, it may not be such as good of a deal.

Cap Rates Relate to Interest Rates in Commercial Financing

The value of commercial properties may vary due to interest rate changes with the Federal Reserve lending rate. Although these are not huge changes, the interest rate on an investor’s loan on commercial real estate may increase — causing the mortgage payment to be higher. This may be only a small adjustment, but it could be enough to have the financing and cost of financing the property impact the cap rate. Investors are always looking to play the difference between a higher yielding cap rate and the market interest rate on the cost of financing the property.

If you are considering investing in commercial real estate, income property, commercial offices or vacant land, your Digsy Expert can show you the cap rate you can expect from your investment in comparison to other similar properties in the area using the latest analytical tools.

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