You remember our friend CAP rate? CAP rate is defined as the unlevered return you can expect to receive on a commercial real estate asset investment. CAP rates vary by asset type, asset class and location. CAP rates also vary over time according to supply and demand.
For instance: CAP rates will likely not be the same for an office building situated in a major metropolitan downtown area and a suburban apartment complex. A suburban apartment complex in one part of the country will not have the same CAP rate as an identical suburban apartment complex in another part of the country. The same office building and suburban apartment complexes may have a different CAP rate next quarter or next year or ten years from now. The point is that CAP rates change.
Let’s look at how CAP rates impact the value of our commercial real estate first. You may know that the value of a piece of commercial real estate is typically calculated like this:
Net Operating Income / CAP Rate = Value of the asset
Let’s take an easy example. Suppose your multifamily property has a NOI of $100,000. The going CAP rate for your class of property in your market right now is 10%. This 10% CAP rate says you will earn a 10% return on your invested dollars if you purchased this asset using all of your own cash.
Calculating the value of the asset using the formula above looks like this:
$100,000 / 10% = $1,000,000
So, if you purchased your multifamily building for $1,000,000 using all of your own cash, you would receive $100,000 per year or 10% return on your investment.
Using the formula above, let’s look at the impact of a changing CAP rate on the value of your apartment building.
At a 5 CAP (a CAP rate of 5%), your property would be worth:
$100,000 / 5% = $2,000,000
At an 8 CAP (a CAP rate of 8%), your property would be worth:
$100,000 / 8% = $1,250,000
You get the idea. And you can see that a varying CAP rate can impact your acquisition costs as well as the value of your investment over the life of your hold period. Finally, CAP rate can affect the timing of any financing events during the hold and the price you are able to demand on disposition. Whether it’s an industrial building, a strip mall or an office park, it pays to pay attention to CAP rate.
CREtirement 