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Understanding Cap Rates in Commercial Real Estate Investing

November 15, 2019

For those interested in investing in commercial real estate, an understanding of cap rates is an important part of their knowledge base. Without knowing how cap rates might affect their investments, they could be less successful in their strategies for passive income and a financially secure future. As a fundamental concept in the real estate investment sector, the cap rate should be well-understood. Unfortunately, that’s not the case for most people. Here’s what you should know to fully understand cap rates and how to use that knowledge to your investing advantage.

What is a Cap Rate?

The cap rate — or capitalization rate — measures the natural rate of return for a commercial real estate property on an annual basis. This rate does not take debt on the property into account, which makes it easier to compare properties in a manner that is fair to relative value. When a single investor or a REIT like DiversyFund is determining what properties to buy, for example, the more direct comparison between properties can mean better investment choices and a more lucrative deal.

How to Calculate Cap Rates

Calculating the cap rate is not difficult. If you’re already comfortable in the finance sector, you can think of the cap rate as being the reverse of the ratio the stock market uses for price-earnings. The P/E ratio looks at the market value (price) of a stock, when divided by the earnings per share. The cap rate looks at a property’s yearly income, as divided by its value (cost). In other words, the cap rate = annual net operating income/value (price or cost). Even if you don’t have stock market experience, you can make the calculation and compare properties you may be considering for purchase.

When to Use Cap Rates

Cap rates should be used when an investor is trying to calculate the yield they can expect on a property on a yearly basis. Comparing the cash flow between two properties, without looking at the debt on those properties, gives an unlevered rate of return that is more natural. In that way, the cap rate can help an investor see what they will really be getting for a yield, and can lead to purchasing properties that will supply stronger income streams. It’s a method of measuring risk and can be very helpful for investors who might not have as much experience, or for those who are looking at properties that may potentially be riskier.

Using a cap rate is common when trying to compare properties in a fair manner. Since real estate can be complex, there are a lot of factors that play into whether one property should be purchased instead of another property. If you want an apples-to-apples type of comparison between two properties, a cap rate can help you get that. Not only will that make it easier to evaluate whether the pricing of the properties is fair, but it will also help investors decipher trends in the market that may affect the number and type of properties they want to purchase in the future.

Consider All Possible Scenarios

Remember that cap rates are not the only considerations for a REIT or an individual investor. While a higher cap rate is better, there are additional factors and scenarios that must be examined, as well. For example, if the NOI or value of the property changes, the cap rate will fluctuate, as well. Additionally, you should consider why the cap rate fluctuated. Did interest rates change based on market demand? That will affect the cap rate, but doesn’t actually change the value of the property. The amount of income produced by that property would also remain unchanged, so a lower cap rate in that scenario would be meaningless.

Using cap rates can help you and other investors make a decision. They are part of what DiversyFund examines when considering whether to add another property to their equity REIT, and they are used by many companies and investors. But they don’t tell the whole story. Short-term investments, fix-and-flip buildings, and related real estate transactions really are not affected by the cap rate. Because the goal is a quick sale and not long-term income generation, it is not possible to correctly apply the cap rate in these circumstances.

Knowing Cap Rates as a CRE Investor

As a commercial real estate investor, knowing the cap rate and how to calculate it is never a bad idea. Knowledge is a good thing for anyone who is working with their finances. By choosing to invest in an equity REIT like DiversyFund, you can avoid the need for cap rate calculations and speculation — but you should still understand the terminology and methodology behind it, to ensure you’re making wise investment decisions. Also keep in mind that cap rates are not equal to cash-on-cash returns, as the latter considers cash flow after making debt payments, and is divided by the total investment.

If you’re ready to start investing or increase the level of your commercial real estate investment, working with a REIT like DiversyFund’s can make it easier. You can have the security and peace of mind that comes with putting your trust in a quality REIT with a focus on shareholder returns.

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