There are many calculations that are indispensable to buyers of commercial real estate, prospective investor must use the right formulas to determine the purchase price for the purchased property.
The Capitalization Rate is the most often used of these formulas. Cap rates are a common commercial real estate barometer used to establish the value of an asset using an income capitalization approach. For an all-cash purchase with, for example, no deferred maintenance, the cap rate is theoretically the same measurement as the rate of return.
Capitalization rate (or "cap rate") is the ratio between the net operating income produced by a real estate asset and its capital cost (the original purchase price paid by the buyer) or the current market value. of the property. The rate is calculated as follows
- Gross Operating Income – Expenses = Net Operating Income (NOI)
- Net Operating Income/Purchase Price = Cap rate
Gross Operating Income: This is the gross rent you collect from tenants or other source of income or cash the property generate.
Expenses: This includes bills such as natural gas, electricity, water and property taxes. This calculation also includes a percentage for maintenance, property management and vacancy allowance. Ask for copies of original bills. If they refuse just move on and find a more honest seller.
Net Operating Income: is the net income after deducting expenses
In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula below:
Cap Rate Reversed
- Net Operating Income/ Capitalization Rate = Capital Cost (asset price)
For example, if a real estate investment provides $320,000 a year in Net Operating Income and similar properties have sold based on 8% cap rates, the subject property can be roughly valued at $4,000,000 because $320,000 divided by 8% (0.08) equals $4,000,000.
A comparatively lower cap rate for a property would indicate less risk associated with the investment (increasing demand for the product), and a comparatively higher cap rate for a property might indicate more risk (reduced demand for the product). Some factors considered in assessing risk include creditworthiness of a tenant, term of lease, quality and location of property and general volatility of the market
This is often referred to as direct capitalization, and is commonly used for valuing income generating property.
One advantage of capitalization rate valuation is that it is separate from a "comparable -market-approach" (which compares 3 valuations: of other similar properties that have sold for with the same comparison of physical, location and economic characteristics, actual replacement cost to re-build the property in addition to the cost of the land and capitalization rates).
Multiple approach are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and other income properties, are usually compared to ensure that estimated revenue is being properly valued.
Owning a real estate property that produce an income is not the golden path to richness as proclaimed in endless programs, courses and seminars on late night television.
Like any other business investment you must make wise investments to get solid return on your investments. It is easy to spend money you don’t need to on unnecessary improvement that don’t return any profit or ad value to your portfolio. Don’t over pay for income properties and think you could just sit and collect income. it take lot of hard work and time and the right management and maintenance team to keep up the property.
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