The capitalization rate (or “cap” rate) is one of the primary measuring tools of any office building investment. It is a short form method of deriving the rate of return based on the purchase price and allows you to compare many properties simultaneously to select the highest yielding. But there are some important considerations required in this area.
What are you really paying?
To calculate the cap rate, the first thing you need to know is how much you’re paying for the property. The total cost. Where many buyers mess this up is that they fail to include any cap-x items required post-sale, such as costly repairs to roofs, elevators or other key infrastructure. This can increase the total out-of-pocket cost substantially and greatly impact the cap rate. So you have to be realistic on what the total price paid is going to be.
What is the real net income?
Next you need the real net income, which is essentially the projected revenue less the operating costs (but not including depreciation). Again, many buyers mess this up by not making a realistic budget based on current events and not future assumptions. Whatever you can do to spike revenue or cut costs should drop to the bottom line and be your profit from taking on the endeavor, not as a means to justify the purchase.
Divide the net income by the price
To derive the cap rate you now divide the net income by the price paid. For example, if you are buying an office building for $1 million that created $100,000 of net income, the cap rate would be $100,000 divided by $1,000,000 which equals a 10% cap rate. It’s that simple. Most people think that calculating a cap rate is difficult, but it’s not. It’s just a fraction.
Identify other elements that could improve net income or lower cost
So what if the existing cap rate is not compelling? Then you can look at what can be done to increase net income or reduce the total cost. This would include renting vacant space, increasing rents on existing space, or reducing utility cost with greater energy efficiency. The bottom line is that this type of “best case” scenario is important for you to build the deal’s “risk/reward” quotient and see if it’s worth the gamble or not.
Cap rates are a hugely important part of the office building analysis process. Now you know how to calculate it and what can impact it. These numbers can help guide you to a successful purchase.