![]() An investor who pays $10 million for a building at a 10% cap rate would expect to generate $1 million of net operating income from that property each year. For example, a 10% cap rate is the same as a 10-multiple. Using a cap rate to value commercial real estate is similar to how investors use multiples when valuing stocks or other equities. The lower the cap rate, the higher the purchase price and vice versa. Cap rates generally have an inverse relationship to the property value. The cap rate is expressed as a percentage, usually somewhere between 3% and 20%. ![]() In commercial real estate, a capitalization rate (“cap rate”) is a formula used to estimate the potential return an investor will make on a property. In this article, we take a look at how to calculate a property’s cap rate, why cap rates are so important when looking to purchase an office building, and some of the key factors that can impact cap rates – as well as uncovering ways seasoned operators uncover hidden value that less experienced investors might miss. Related: Why Cap Rates are a Blunt Instrument in Office Building Valuation It is not uncommon for cap rates to be misused as a blunt instrument to calculate a building’s value without assigning sufficient weight to the nuances of the tenant mix and related leases. Despite the frequency with which cap rates are referred to in the commercial real estate industry, many people do not understand how they work. One of the ways investors compare commercial real estate properties is by looking at the property’s capitalization rate, or “cap rate”. In either case, the investor now must compare available properties to understand which is the most lucrative investment opportunity. Or maybe they want to invest in commercial real estate to diversify their holdings. Maybe they feel this property will have the best return based on the current state of the economy or given the specific market in which they’re looking to invest. Let’s say an investor decides to invest $100,000 in commercial real estate. If someone has $100,000 to invest, for example, they’d want to look at many different investment vehicles (stocks, bonds, commercial real estate, and more) and consider the potential returns of each, and on what time horizon. In order to evaluate whether a particular property will be a good investment, it must be compared to other investment opportunities. And by good deal, they usually mean – will this particular property generate strong returns? When considering whether to purchase commercial real estate, it is natural for an investor to question whether a specific deal is really a “good deal” or not.
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