Hello. I wanted to write a short description on how "Cap Rate" applies to commercial, investment property. I like the cap rate number because it is easily understandable since people are used to paying interest on borrowed money and receiving interest on deposits. Cap rate strives to answer a simple question.
What is the effective interest rate that this investment yields? I like to use the analogy of deposting money into a bank account. If you were to deposit an amount of money equal to the purchase price, the cap rate would equal the interest rate that the bank is willing to pay on your deposit.
For Example:
If you are purchasing a commercial apartment complex for one million dollars ($1,000,000.) and the listing agent represents that it has a 10% cap rate, then the property should net profit one hundred thousand dollars ($100,000.) annually. Ten percent of one million is one hundred thousand.
Simple, right... Well here is where the problems definitely start to come out in the details.
First: The cap rate is calculated on the net income of the property (IE gross rent, less vacancies, less utilities, property taxes, insurance, maintenance, advertising, management,... etc.). It does not include any debt service. This is as it should be, since a 10% cap rate property should return the same for an all cash buyer as it does for a 90% financed buyer. You do not want to confuse cap rate with cash flow.
Second: The expenses that the current owner is having may be lower or higher than you would experience. If you purchase this property and your expenses increase by sixty thousand dollars ($60,000) annually, then your cap rate is reduced to four percent (4%) and your annual profit would decrease to forty thousand dollars ($40,000.). You may have been better off keeping your money in the bank.
Third: Income is primarily generated from rent collected. If you have a significant increase in vacancies due to a transfer of ownership your cap rate is affected as well. You definately can maximize your profit by keeping a sharp eye on the occupancy. Most of the money that you end up keeping is from the last 15% of apartments and your ability to keep them rented.
Fourth: Your debt service is paid out of the proceeds after all expenses are taken out. You can easily end up with a property that makes money on paper but that you have to come up with money every month to pay the bills and the mortgage. This is what I affectionately call an "Alligator property" because every month it is taking a bite out of your available cash. Ouch.
There are many aspects to commercial investment property that can be a double edged sword to the owner. Each item that affects your "cap rate" can also be used to improve it. The key is to understand the terms that are presented in the property listing and knowing how that applies to your specific investment needs.
