Understanding cap rates in commercial property
IF YOU are planning to invest in commercial property, you will have heard of the term capitalisation rate, or cap rate for short.
Understanding cap rates is an important tool for comparing different commercial properties and helping choose a property that suits your requirements.
The cap rate is a percentage value representing how much income a property delivers proportion to its value.
It is calculated by dividing the property’s net annual income by its current market value or purchase price and multiplying this figure by 100.
Cap rate = (net annual income ÷ purchase price) x 100
Suppose a property has a net annual income of $32,500 after expenses and the purchase price is $500,000 - this would provide a cap rate of 6.5%.
The net annual income is the income the property generates after operating expenses such as council rates, body corporate fees, maintenance, insurance and management costs are deducted.
It is important to note, this rate does not factor in borrowing costs, income tax or capital expenditure costs.
All things being equal, investors will usually seek a higher cap rate, however, generally a higher rate equals higher risk.
A higher cap rate may indicate a secondary location, an older property or short-term lease.
Conversely, a tight cap rate is typical of a blue-chip investment, a long lease in place and a prime location.
The lower return is the price paid for capital preservation and income security.
Market conditions such as interest rates, inflation and the economic climate influence investor expectations of desired cap rates and often vary between city and regional areas, as well as across different classes of commercial property (such as office, industrial or retail).
We are currently seeing average cap rates in the local area sit around 6 – 8%, however this varies between each property.
A cap rate is a handy metric used to assess the potential return of a property, however it is just one element to consider when purchasing a property and due diligence on the property, lease and tenant is vital.
To discuss how these local market cap rates might apply to your investment goals, speak with an experienced commercial real estate professional.
LINDA BLAND
Principal / Licensee
www.c21chb.com
