Real estates rented to one or more renters are considered as commercial real estates. Shopping malls, office buildings, industrial buildings etc. are in this class. While buying a commercial real estate, yield must be taken into consideration and it should be evaluated if that action worth it or not. At this point, cap ratio must be considered in real estate investment.
Other options must be considered as well while evaluating the investment to be made. For example, if 100.000USD will be invested, related yield must be compared with the yield of similar investment options. It should be checked how investment values change in time.
The easiest way for investors to compare commercial real estates is to check this ratio, which is also known as capitalization value of property. Then, how to calculate cap ratio in real estate investment? How important is it and what are the factors that affect this raita?
What Is Cap Ratio?
Cap ratio for a commercial real estate is a special formula used to estimate potential return of investment to be obtained by an investor over a property. In this formula, upper cap is generally between 3% and 20%. Border ratio and property values are generally inversely proportional. That means, the higher a property’s value is, the lower upper cap value will be.
Using upper this ratio in commercial real estate evaluation is like using multipliers while evaluating stock shares. It can be said that these two concepts are similar.
For example, 10-multiplier is the same as 10% upper cap ratio. If 10 M$ is paid for a building with 10% upper cap, the investor should obtain 1 M$ net income every year. Despite this, if 500k$ is obtained, that means the upper cap is 5%.
Non-liquid nature and comparatively complex structure of commercial real estates make it difficult to perform some calculations.
Read Also: 10 Steps Real Estate Investors Should Follow in Crisis Periods
How to Calculate Cap Ratio?
To calculate this ratio in commercial real estate investment, the following formula is used.
Cap Ratio = Net Operating Income / Property Value
Net operating income is obtained by subtracting expenses from a commercial real estate’s value. Shortly, it is net profit for an investor. Property value is considered as sales value of a property. For this calculation, the following steps should be followed.
Step 1:
First, you must determine the value of your commercial real estate. For this, you can benefit from different online tools. Yet, don’t forget that online evaluation tools may not always provide the correct result.
In this topic, you can receive professional support. By considering existing market conditions, you will be provided detailed information about your real estate by an appraiser. If you want to be sure while determining your property’s value, you can consult multiple appraisers.
Step 2:
Determine the value of your commercial real estate. At this point, all factors that bring in money should be considered. Day-based calculations to determine net income can be stated as correct method. For example, record your daily income for one month and at the end, learn your net income.
If you haven’t purchased the property yet, it will be enough to check other similar properties in the market. You can get information about those properties’ rental income and side income.
Step 3:
Determine the expenses of your real estate. Sum all expenses like subscription fees, insurances, taxes and similar expenses. This way, you will learn how much your expense is. After calculating your expenses, subtract it from the net income you previously calculated. This way, you will find your net profit. This factor should be considered as well to find a profitable apartment.
Step 4:
The last step to calculate cap ratio in real estate investment is to divide your net income by asset value.
For example, let’s assume that your asset value is 300.000€. Your net income is, on the other hand, 16.800$. These values will provide 5.6% when 16.800 is divided by 300.000. That means, cap ratio here is 5,6%
Importance of Cap Ratio While Purchasing a Property and Workplace
While purchasing a commercial real estate, it will be realized that cap ratios are not equal. Each property may have different value and return of investment. Accordingly, ratios will also be different. On the other hand, you should consider the fact that the cap ratio you would calculate may not reflect the actual situation.
For example, while comparing two buildings, some factors will be important like occupancy rate, due dates of rental contracts, credibility of renters etc. Accordingly, cap ratio may vary.
Let’s assume two properties, both worth 10M, Property A with 300.000$ net income and Property B with 700.000$ net income. As a result, cap ratio for Property A is 3% and for Property B, it is 7%. Upper cap ratios here are important factors both for buyers and sellers. When these ratios are considered, it can be thought that purchasing Property B will be a better option. Yet, occupancy rate and credibility of the renters must be considered as well.
Cap ratios are also considered as risk ratios of a property. It can be said that properties with high cap ratio also have high risk. Yet, buildings with higher risk can be purchased by investors for lower values.
Cap ratio is an important criterion in real estate investment. Yet, it shouldn’t be used as a stand-alone metric. Because this value never shows the whole picture to you. Without seeing the whole picture, making a commercial real estate investment is a big risk. This is because cap ratios depend on renting-at-place. The evaluation must include some details like how much and when rents will be increased or how will occupancy rate be.
For example, some renters at the property to be purchased may be paying lower rent than market conditions. If their contract will end soon, this is a good advantage. Because a new contract can be signed with higher price and accordingly, net income can be increased. In this case, cap ratio will be higher than now.
Factors That Affect Cap Ratio
Cap ratio is an important factor in real estate investment. Yet, there are some factors that affect this. Knowing them will result in better evaluations. Explanations about these factors are as below:[1]
Location of the Property
Location of the property has high importance. The better its location is, the lower its cap ratio will be. Accordingly, there will be lower risk factor. Existing value of a property can be conserved if its location is good – it even can be increased. However, this is not the same for properties with bad location. This situation makes many foreign investors select properties with good location even 5% lower income will be the case.
Position of a property in the market is also important. Properties located in city centers have higher prices than other areas. This means lower cap ratio.
Status of Existing Market
In case real estate market is going well, value of a purchased property will increase after a while. Therefore, upper cap will decrease. If not so, cap ratio and risk will increase. Properties with low cap ratio are preferred in bull market whereas properties with high cap ratio are preferred in bear market.
Market Ratio of Rents
Cap ratio in real estate investment is extremely affected by rents. If rental values at the respective property are low, there will be significant increase in cash flow after contracts are renewed. Because of this situation, investors may pay more money for properties rented for lower prices.
Rental Periods
Rental periods affect upper caps. Shorter rental periods will result in higher risk. This situation may bring worse problems than estimated. Accordingly, cap ratio increases and property value decreases.
Properties with only one renter include much higher risks. Bankruptcy of that renter or renter’s leave due to another reason may affect property value negatively. By renting a property to multiple persons and gradual rental periods, such risk may be reduced.
Property’s Existing Situation
Properties with good physical condition require less maintenance. This situation causes lower cap ratio and risks. Accordingly, property value increases. Therefore, while purchasing a property, it should be examined thoroughly. This way, necessity of any maintenance will be determined.
Read Also: Real Estate Investment for Beginners: Profitable Strategies
How Should a Good Cap Ratio Be?
Cap ration may be at different levels in real estate investment. Some aggressive investors are interested in properties with more than 8%. But, in general, it can be said that a property with cap ratio of 6% is ideal.
For investors who don’t like taking risks, properties with 4% or 5% cap ratio would be suitable. This way, risk level is reduced and income stability is ensured more easily.[2]
RESULT
Cap ratio in real estate investment is one of the most important signs of how commercial assets will perform. However, it shouldn’t be used alone in any case. Otherwise, it may result in wrong investment decisions. The main thing here is to evaluate other indicators like cap ratio. Except these, cap ratio decision may vary depending on an investor’s general principles. Investors who like to take risk prefer properties with higher cap ratio whereas investors who don’t like taking risks may go for lower cap ratio.
Our company, which provides real estate consultancy service, evaluates all factors studiously on behalf of you. Our experts experienced in cap ratio topic will ensure that you make the best investments. This way, you will take low risk and obtain high return on investment. Additionally, we provide support for legal topics as well. To get more detailed information about this topic, you can contact us.
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Igors Krumins continues his activities as a commercial and international lawyer within the body of “Jurmala Invest”. He has more than 10 years of experience, especially in the investment sector, and has provided consultancy services to numerous companies with his legal expertise. He successfully completed his undergraduate studies at Baltic International Academy and graduate studies at Latvijas Universitate. Apart from his native Latvian language, he can also speak Russian and English fluently.
