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Jun 4
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“Cap Rate” is a term that is thrown around in the commercial real estate world much like “RBI”, “base hit” and “strikeout” are used in baseball circles. Essentially, a cap rate is a fundamental measurement of the financial performance of a commercial property. More importantly, a cap rate has significance as a relates to relative price of different properties. If I say that “I purchased a building at a 7 cap (rate),” I am really saying that the gross triple net (NNN) cash flow from the underlying leases is 7% of the total purchase price of the building. Let me put it another way, if I buy a building for $1,000,000 and its leases generate $70,000 of cash flow per year after I pay for taxes, janitorial/maintenance, and utilities, I purchased the building at a 7 cap or a 7% cap rate. However, if I purchase that very same building, with the very same lease and expenses for $700,000, I effectively purchased the building at a 10 cap. When experienced commercial real estate folks discuss real estate, they almost always discuss their transactions in terms of cap rates. For example, I was in Mexico last week discussing some real estate opportunities with a local broker. As I tried to educate myself about the market, the broker said the following, “This is an extremely strong market. In fact, just last month I sold a downtown building in San Jose Del Cabo at a 10 cap to a group of investors from the States.”
His message to me was “Hey, if you want to make an investment in this part of Mexico, I can get you some great properties at attractive prices.” The message was well received and I am currently looking at this market for potential investment opportunities. With this one sentence, he was also comparing the Los Cabos market to the United States. His point was very simple, you can get better prices for similar properties in Mexico as compared the United States. If what the realtor in Los Cabos was saying is true, he is making a very good point. In the United States, commercial properties are historically very expensive. Although cap rates vary from market to market, most cap rates in the United State today range from 5% - 9%. Downtown and prime commercial real estate cap rates generally start at 5% - 6.5% and other locations go up from there. An investor may find cap rates higher than 9%, but those are becoming increasingly hard to find in most strong commercial markets. Traditionally, cap rates have been much higher, but with strong liquidity in the market, cap rates have been forced down, thus giving way to higher prices. This brings me to my next point; there is an inverse relationship between cap rates and price. In other words, the higher the cap rate, the lower the price. Conversely, the lower the cap rate, the higher the price of the property. The inverse relationship is best shown by examining the formula for finding the cap rate of the building. The cap rate formula is as follows: Cap rate = NNN cash flow/Total price of the building, OR Price of the building = NNN cash flow/Cap rate, where the cap rate is expressed as a percentage (e.g. 7 cap equals .07, 8 cap equals .08, 9 cap equals .09 and so forth).
So, going back to my previous example, I purchase a building for $1,000,000 and it generates $70,000 of NNN income per year, then, the cap rate formula is expressed as follows: Cap rate = $70,000/$1,000,000 = .07 = 7% cap rate or 7 cap.
Or, if I am trying to determine the price of that same building and I want to purchase the building at a 10 cap, the formula looks like this: Price = $70,000/.10 (10 % cap rate) = $700,000. Next column: Why NNN leases?
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