Commercial real estate (CRE) investing can support your estate planning goals by potentially generating passive income and building wealth for you over time.
In this article, we’ll break down what these metrics mean and how they impact commercial real estate investments.
Understanding Cap Rates
Cap rates represent how much you could reasonably be expected to receive in annual income for every dollar paid to acquire an equity position in the property. It’s found by dividing a given property’s net operating income (NOI) by the property’s value. Generally, higher cap rates imply greater risk, though cap rates should be viewed in the context of like property types. Industrial properties like warehouses have different risk and return profiles than something like office buildings, a difference represented in cap rate trends for each property type.
In general, cap rates tend to be lowest in properties that exhibit lower sensitivity to changes in economic conditions. Historically, that meant that office buildings and multifamily properties offer the lowest cap rates on the basis that people need a roof over their heads, whether they’re sleeping or working. Retail and industrial properties tend to be more sensitive to economic conditions than office or multifamily, though less sensitive than hotels and specialty properties.
Net operating income (NOI) is a critical metric to consider when evaluating the profitability of an income-producing property. It’s calculated by subtracting all operating expenses from the total revenue generated by a property. This calculation gives investors a better understanding of how much money they can expect to make from their investment, and it helps them determine whether the property is worth purchasing.
When calculating NOI, it’s important to include all operating expenses such as maintenance costs, property taxes, insurance, and utilities. By subtracting these expenses from the total revenue generated by the property, investors can get a more accurate picture of their potential return on investment.
One thing to keep in mind is that NOI does not consider any financing costs or taxes associated with owning the property. However, it remains a valuable metric for investors because it provides insight into how well a property is performing operationally.
Relationship Between Cap Rates and NOI
As NOI indicates how much revenue a property generates after accounting for all expenses, cap rates are used to determine the value of a property based on its expected return on investment.
The relationship between cap rates and NOI is inverse, meaning that as cap rates decrease, the value of the property increases, and vice versa. This is due to lower cap rates indicating higher demand for properties with potentially higher returns. Alternatively, a higher NOI means that a property is generating more income after taking into account all operating expenses.
Changes in either metric can have significant implications on a property’s value. For example, if there is an increase in demand for commercial properties in the greater Phoenix Valley area in Arizona, with limited supply, while the rents remain consistent and/or increase marginally over time (resulting in higher NOIs), then investors can expect lower cap rates as more buyers compete for investments with potentially higher returns.
It’s important to note that both cap rates and NOI should be considered together when evaluating the profitability of a property. A low cap rate does not necessarily mean a good investment if the NOI is also low. Conversely, a high NOI does not necessarily mean a good investment if the cap rate is also high.
Using Cap Rates and NOI in Investment Analysis
Using Cap Rates and NOI to analyze your investment is just one aspect of a comprehensive investment evaluation process. While Cap Rates can help you understand how much you should pay for an investment relative to its future earnings potential, NOI helps you evaluate whether an investment will generate enough income to pay off any debt associated with it.
In addition to Cap Rates and NOI, you can use other metrics such as cash-on-cash returns (CCR), internal rate of return (IRR), and equity multiple (EM), among others to give you a clearer picture on your potential investment. These metrics provide additional information about the risks involved and overall profitability potential before committing funds towards acquisition financing or development projects.
Cash-on-cash returns (CCR) measure the annual return on the actual cash invested in a property. It’s calculated by dividing the annual pre-tax cash flow by the total amount of capital invested. Internal rate of return (IRR) measures the overall rate of return on investment over time. Equity multiple (EM) measures how much money investors can expect to receive over their initial investment.
It’s important to note that no single metric provides a complete picture of a property’s value or potential profitability. Instead, investors should consider all relevant metrics together when making investment decisions. They can also consider using a third-party fund sponsor to help you evaluate your potential investment options.
Using cap rates and NOIs is an essential practice when you are evaluating potential commercial real estate investments. These data points can help you assess the various risk levels associated with different properties, based on their expected returns on investment, while also providing you with the insights to help you determine whether an investment will generate income at the threshold you’re looking for. The income generation capacity process is necessary for paying back any associated financing costs over time periods required per project needs.
By considering these important indicators during your analysis process, you can make better-informed decisions that support your estate planning goals.
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