When investing in commercial real estate, there are several factors that can be used to value a property. While market rates do dictate prices to a certain extent, those rates still rely heavily on what is termed a CAP rate. The CAP rate, or CAPitalization rate, is a simple equation that divides the cost of acquiring the property by the annual rate of return.
Using the CAP rate as a guide, a building that costs $100,000 to buy and returns $5,000 in income would have a CAP rate of just 5%. If other commercial properties in the area have CAP rates of 7% or 8%, then the purchase price could be considered to be too high. Of course, CAP rates are really just a starting point.
When comparing commercial real estate, CAP rates indicate the rate of return based purely on the initial cost of the property. If the buildings are a little run down and require an injection of funds to undertake repairs, then that cost of $100,000 becomes far too uncompetitive using a 5% CAP as a guide. Furthermore, you need to consider whether or not the current income is sustainable given the building’s current condition. If the current tenant decided to leave, could you quickly replace them?
Buying commercial real estate can be a risky business. While many buyers use CAP to determine a building’s worth, it should only be used as a guide. If you add all the costs together – that is, the purchase price, interest paid on any money borrowed, buying costs (taxes, for example), and any costs to make repairs, you gain a much better indication of a building’s real cost to you. By using net income rather than gross, you will be able to determine your actual return on your investment. Some investors incorporate other data including the buildings possible appreciation in value. You can technical, however, for the purposes of valuing a building, try to keep it as simple as possible.
With those numbers at hand, you can gain a real indication as to which property is the best value when it comes to investing your money. Commercial real estate is not like the housing market. You cannot compare like buildings to gain an indication of the building’s value – you need to determine its future value as an investment.