According to Wikipedia the cap rate is a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost of that asset.
Now that we have the definition out of the way, what is the cap rate used for? While those involved in a commercial real estate transaction often use the cap rate as a selling tool, they often don’t use it correctly and shortcut the true use of a valuable tool.
So what does the cap rate really tell you? The cap rate assumes the property is being purchased with cash. It doesn’t tell you what your return will be if you finance the purchase of the asset. It also doesn’t take into account different finance terms that individuals may have available to them for any given transaction.
So in reality the cap rate only tells you what the project return would be for the incoming producing property assuming it was purchased with cash. As the buyer or leasee of an income producing property you need to take these variable into account before making your final decision on the property.
Brokers often quote the “market cap rate” when talking to potential purchasers of a property. They do so to legitimize an assumption, but in most cases it is flawed. As a comparison tool it is almost impossible to find out what comparable properties have sold for based on the cap rate alone.
You are at the mercy of the listing broker as to the validity of the cap rate number associated with a listing. To have an accurate cap rate number you have to know the income and expenses of the property. This information is not part of any public record and unless the business itself is being sold along with the property, you can ask for this information but by no means is anyone obligated to provide it.
So while the cap rate can be a very useful tool, if calculated correctly and supporting documentation is provided to support the rate, often times the rate is calculated incorrectly, used incorrectly, and used simply for a marketing tool to get more return for the property when it is listed. My suggestion is to work with a broker that will be able to help you truly find out the property’s value through other means besides the cap rate alone. Also, do your homework and work with your broker to pull up other recent comparable properties that have recently sold that had a similar type of business in a similar type of property. This will go a long way towards making sure that you are getting the best value when looking at income producing properties.
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