When evaluating commercial real estate investments, capitalization rate (cap rate) is a key metric that helps determine a property’s potential return. But what exactly is a cap rate, and how do you calculate it? Let’s break it down.
What is a Cap Rate?
A cap rate is the rate of return on a real estate investment property based on the income it generates. It’s commonly used to compare different investment opportunities and assess risk levels.
How to Calculate Cap Rate
The formula for calculating cap rate is straightforward:
Step 1: Determine the Net Operating Income (NOI)
NOI is the annual rental income generated by the property minus operating expenses (excluding mortgage payments and depreciation). For example, if a property generates $100,000 in rental income and has $30,000 in operating expenses, the NOI would be:
Step 2: Identify the Purchase Price
If the commercial property is purchased for $1,000,000, then:
What is a Good Cap Rate?
Cap rates vary by property type, location, and market conditions. Here’s a general guideline:
- 5% – 7%: Common for stable markets with lower risk (e.g., prime office buildings, retail spaces in high-traffic areas).
- 8% – 12%: Higher-risk properties or emerging markets with greater income potential.
Limitations of Cap Rate
❌ Doesn’t Factor in Financing – Since mortgage payments aren’t included, cap rate only evaluates property income, not overall investment returns.
❌ Market Dependent – Cap rates fluctuate based on economic conditions and real estate trends.
Why Cap Rates Matter
Understanding cap rates helps investors make informed decisions. Whether buying or selling commercial real estate in Indiana, knowing how to calculate and interpret cap rates can be the difference between a smart deal and a costly mistake.
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