Sometimes looking at commercial real estate language feels like learning the language of quantum physics. At first glance, the language seems overly and unnecessarily complex. But just like quantum physics, or any other profession, the language is there for a reason, to ensure accuracy and specificity.
According to Investopedia, Cap Rate, short for Capitalization Rate, is the expected rate of generated return on an investment property. While it’s not exactly quantum mechanics, it does involve some simple math. Basically, Cap Rate is a percentage calculated by dividing the net operating income by the property asset value. It’s not meant to be the only measure used to estimate the profitability of a property, but is a useful tool to get a rough idea of an investor’s potential return on a commercial real estate investment.
Capitalization Rate = Net Operating Income / Current Market Value
There are other ways to measure Cap Rate, but this method is the most common and a good place to start understanding the subject.
Net Operating Income
Since we use Net Operating Income in our formula, we should go ahead and explain what that means in commercial real estate. Bungalow defines Net Operating Income (NOI) as “a real estate term representing a property’s gross operating income, minus its operating expenses. Calculated annually, it is useful for estimating the revenue potential of an investment property. NOI is not affected by how you finance a property—whether you get a mortgage or buy with all cash.”
Net Operating Income = Gross Operating Income – Operating Expenses
Current Market Value
This one is more complex than we have time for in a blog, but it’s worth reading Investopedia’s summary of Current Market Value as it relates to commercial real estate. In fact, this site is a good resource for many terms you’ll encounter in commercial real estate. But as with any online resources, it’s often worth finding more than one source if you’re looking to truly understand a topic.
You can also always reach out to us with questions about complex property language. We’re here to help and we would rather take the time to fully explain a topic than leave you confused. We’re certainly not experts in our clients’ businesses, and don’t expect you to be an expert in ours. We’re here to help every step of the way. Never hesitate to get in touch.