Image by mohamed Hassan from Pixabay
Let ’ s say for example that : The market Cap Rate for a commercial property with triple net leases (“ NNN ”) has been determined to be 6.5 %. The 10,000 square foot multitenant property under consideration generates monthly rents of $ 1.50 per foot . After applying a 10 % vacancy collection and loss factor and expenses of 5 % for management and reserves , the NOI is $ 153,900 .
10,000 sf X $ 1.50 = $ 5,000 Per mo . X 12 Mos . = $ 180,000 gross income
$ 180,000 – $ 18,000 10 % vac . = $ 162,000 – $ 8,100 5 % exp . = $ 153,900 NOI
$ 153,900 NOI / . 065 Cap Rate = $ 2,367,692 asset value
From an investment standpoint Cap Rates can also indicate a prevailing rate of return before debt service and can help a lender / investor to measure both return on invested capital and profitability based on cash flow . An informed lender / investor should understand that there may be dramatic variations in a property ’ s value when unsupported or unrealistic Cap Rates are applied .
Why do we use Cap Rates ?
The capitalization approach is used as a “ comparative method ” of valuing property based on similar geographic locations , similar properties , and similar risks that would yield a comparable rate of return . Once the value is established , the loan to value ratio can be calculated to determine if it falls within loan underwriting guidelines .
Of course , Cap Rates are only one metric . They represent a snapshot of the market at the time of investment and they do not take debt service or financing costs into consideration . Therefore , if a borrower is going to finance his investment , as most people do , then further analysis such as cashoncash return would be useful . Sophisticated loan underwriters and investors will also do an Internal Rate of Return calculation . These calculations assist in establishing that the collateral property is not only income producing but a worthwhile investment .
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