The capitalization rate, or cap rate, provides investors and landlords with valuable insight regarding the specifics of commercial real estate investments. If interpreted properly, the cap rate can be used by investors to compare and contrast similar investment opportunities, and landlords can include it in their decision as to whether or not to sell a commercial property. There are several instances in which cap rate can be leveraged as an effective metric, but it is often misinterpreted, misunderstood or misused. Below are the most common mistakes associated with cap rate in terms of commercial real estate investments.
Mistakes Calculating Cap Rate
Though the cap rate formula is straightforward on the surface, its very few components, net operating income (NOI) and overall property price, are comprised of complex elements. A cap rate is often a projection of future expectations, and inaccurate NOI estimates will significantly affect the resulting percentage.
The factors involved in calculating NOI include complicated and ambiguous terms such as expected vacancy or alternate income. These pieces are influenced by an overwhelmingly large pool of external forces and can fluctuate frequently and unexpectedly. It’s imperative to precisely calculate each step of the NOI formula before determining a property’s cap rate.
Misunderstanding Limits of Cap Rate
Cap rate should never be used as the sole deciding metric for an investment property. Countless other factors must be considered before choosing to buy or sell commercial real estate. Cap rate alone is not an effective assessment for short-term investments as it does not account for the value of potential improvements or appreciation.
Additionally, cap rate on its own does not consider the time value of money, which makes it difficult to apply to long-term investments. A cap rate serves merely as a glimpse at the one-year expected rate of return based on previous averages and should not be used for more than it’s intended.
Furthermore, cap rates are limited indicators, as they can be considered high in one market, and low in another. Location, supply and demand, types of property, types of leases and other factors all have a significant impact on the cap rate value and worth.
Misinterpreting a High or Low Cap Rate
One of the most common mistakes investors make when interpreting cap rate is assuming that a high cap signifies a better investment. Though a high cap rate does present the opportunity for higher returns and a lower overall purchase price, it also indicates a higher risk. A property with a high cap rate may be in a less desirable location and have a higher vacancy and older amenities, whereas a property with a low cap rate is often well-managed, up to date and in a popular neighborhood with hardly any vacancies. As a general rule, a high cap rate signifies higher risk and a low cap rate signifies lower risk.
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