Valuating Investment Properties Using Cap Rates!
Investment properties are valuated using several criteria, one of the most important which is capitalization rate (a.k.a. cap rate), which is the ratio of the net operating income a property generates to the purchase price or value of the property. For example, if you pay $2 million for a property that has an annual net operating income of $140,000, the property’s annual cap rate would be 7%. A good cap rate is one that generates a meaningful amount of cash flow. What level of cash flow is “meaningful” depends the return you are willing to accept for the risk you take when investing in a property.
TYPES OF CAP RATES
Commercial investment property brokers commonly refer to 2 types of cap rates:
- a “going in cap rate”
- an “average cap rate”
The former is the projected cap rate for the first year of owning a property, while the latter is the projected average cap rate over the course of the lease. Although going in cap rates are known for being more accurate than average cap rates, the latter can be quite useful for valuating investment properties whose tenants have demonstrated a stable net operating income year after year, thus making it easier to predict an average cap rate over a long period of time.
To legitimize projected cap rates that are used for property valuation, investors refer to market cap rates that are extracted from recently completed real estate transactions. However, it is important to note that cap rates for similar types of commercial investment property can vary. For example, a Walgreens located in Florida may have a different cap rate than a Walgreens located in New York due to a difference in location, consumer access, lease terms, market demographics, and other factors. This is why it is important for investors to consult an experienced broker before they decide to acquire a particular property.
Call Jeff Gitt 314-757-1031 at Westwood Net Lease Advisors to discuss these topics and many more to learn all your options!