🌇Don’t Mess with Commercial Real Estate Unless You Know This
Happy Monday!
Here is an Idea, an Action, and a Question to consider this week.
Idea
When I joined the military, I was plunged into a never-ending flow of confusing acronyms and phrases. As I moved into military aviation, the jargon became even more specific. Then, when I entered the world of fighter pilots, I faced even more complex social norms, rules, behaviors, and expectations––all employing yet more lingo.
I loved it!
And each step of the way, the more I mastered the vocabulary, the faster I could master everything else.
The social rules and language of fighter pilots are unique. The life-or-death mindset and intense history have led to colorful phraseology, restrictions, expectations, songs, and habits within that community. Even simple things such as pointing with your finger instead of your elbow or being one second late to the “hack” (or start) of a brief could get you publicly ridiculed or reprimanded.
I learned the fighter pilot language the way you would learn any other: through study, exploration, and immersion. You can do the same with REI lingo. While the world of real estate investing is not a life-or-death environment, the community has still developed its own set of acronyms, phrases, and expectations. If you want to fit into the REI crowd, learn to speak like they do!
Let’s be study partners today, shall we? Today’s term is certainly important in the current market: Cap rate.
Cap rate, or Capitalization Rate, a metric that every real estate professional should have in their arsenal during these times if they’re considering commercial real estate.
To determine value in commercial real estate, you cannot simply look at comparable sales (which is the common method of determining value in residential real estate) because there are too many differences between one commercial property and another. Instead, value in commercial real estate is determined by how much money a property can produce (i.e. a property’s Net Operating Income (NOI)). Cap Rates are the metric used to compare commercial property values within a certain geographical area along with the known sale price and NOI.
Cap Rate = NOI/Value
If you know that Apartment Complex A, which has 100 nice, medium-sized units, recently sold for $10M and last year had an NOI of $600K, you can use the formula above to determine the cap rate is 6%.
You can now apply that Cap Rate to Apartment Complex B, which you are considering purchasing. It has 65 nice, medium-sized units and made $500K last year. You use the formula of Value = NOI/Cap Rate and determine its value is $8.3M.
Basically, the cap rate is the ‘going rate’ in the area, and it’s a way to make reasonable comparisons. It's also worth noting that when cap rates go down, property values go up.
In a down market, property values tend to decrease, but that doesn’t always mean the potential income those properties can generate diminishes at the same rate. This discrepancy leads to higher Cap Rates, indicating potentially higher returns for investors.
For agents, this is a beacon of hope. By identifying properties with favorable cap rates compared to the average rate in the area, you can guide your investor clients towards deals that make sense for their portfolios, even in less-than-ideal market conditions. It’s a way of demonstrating deep market knowledge and showing clients that, even in a downturn, profitable ventures exist.
Action
Identify three properties currently on the market and calculate their cap rates. Get skilled at this kind of deal analysis.
Question
Have you ever missed out on a good investment opportunity because you overlooked the significance of the Cap Rate?
See you next week,
Matt “Roar” Gardner
Real estate investor-agent, Author of Supersonic Real Estate: Light Your Afterburner to Accelerate Your Investor-Agent Career (Coming Soon!), and keynote speaker.
