Commercial Real Estate & Capitalization Rate (CAP)
October 15th, 2007 Posted in Investing, GeneralThe capitalization rate or CAP rate is a means to measure the cash flow ratio with its capital cost or in some instances the current market value and it is derived by simply dividing the annual cash flow by its cost or value. Thus, a building costing one million dollars that produces one hundred thousand dollars by way of positive cash flow in a year would be said to have a CAP rate of ten percent.
You can use the capitalization rate to measure the speed with which your investment will pay for it in terms of net cash flow, and if the example above is considered then this would result in the building being completely capitalized in ten years.
The advantage of having a higher capitalization rate with respect to investing in commercial properties is that when such a rate is high you can expect high rental income from the commercial property and that would translate into requiring less down payment amounts. Thus, if you were an experienced real estate investor you would immediately write off those commercial properties having low capitalization rates and would even prefer to invest in commercial property with capitalization rate higher than the rate of interest paid for loans taken.
There are several different types of capitalization rates that you will come across when wanting to invest in commercial properties and you should be well acquainted with each so that you get the best out of your investment. Thus, look at net, proforma or gross CAP rates that are often used by brokers and know the most appropriate one, if you don’t want to end up paying more than is appropriate for the commercial property.
