Whenever an investor is looking to purchase a commercial property, they want to know how much income it will generate. Whether it is a commercial space, office space or an apartment complex, having a good idea of the return on the investment is crucial, especially when comparing similar properties.
A common way to calculate this return on an investment is by using the Cap Rate (shorthand for capitalization rate). Defined by Investopedia as “the rate of return on a real estate investment property based on the income that the property is expected to generate,” the Cap Rate is an estimate of an investor’s annual return on their investment. Investopedia provides the following formula for calculating Cap Rate:
Capitalization Rate = Net Operating Income (NOI) / Current Market Value
The Net Operating Income (NOI) is important to know as it indicates the total positive income generated by the investment property. NOI is what is left once Operating Expenses (variable costs and fixed costs) have been paid from Gross Income: This is reflected in the following formula:
NOI = Gross Income – Operating Expenses
A Practical Example
Once you know the NOI, you can calculate the Cap Rate. Below is a practical example of the Cap Rate formula in action:
If a buyer purchases a building at the Current Market Value of $1M which then creates $100,000 of NOI annually, then the following is true:
$100,000 / $1,000,000 = 0.10 (10%)
In this example, the Cap Rate is 10 percent. In other words, one-tenth of the total cost of the property value is paid by that year’s NOI.
Indication of Property Value
At the most basic level, the Cap Rate represents the percentage of return an investor would receive annually on a cash purchase. However, this simple formula does not take other factors into account.
When comparing two or more properties for investment, in general, a lower Cap Rate indicates a higher property value. The inverse is true as well – a higher Cap Rate indicates a lower property value. To put this into equations:
Lower Cap Rate = Higher Property Value
Higher Cap Rate = Lower Property Value
Calculations for Office Buildings
For Office Buildings, the Cap Rate can be determined by using the NOI of other comparable properties and the selling prices of recently sold commercial properties. Also, by knowing the income of a property, a more accurate determination of its value can be made.
If the NOI is not published for a certain property, a commercial real estate agent can help you find that information. In addition, sales data on comparable properties can be obtained by working with an agent as well as from the local tax office or from research reports from local agents.
By taking all of the expenses into account, a relatively solid comparison can be made between similar properties revealing perceived discrepancies in property costs. As an article from The Balance says, “When two properties seem just alike and one costs more, it could be because it is generating more income or has lower expenses.”
Calculating Cap Rate as a Guide to Office Building Investment
Determining the value of an office building for investment purposes might seem complicated, but by calculating the Cap Rate, a fairly accurate value can be obtained.