Let's suppose you have just inherited $200,000 from your grandmother. (Sorry for your imaginary loss.) You could take this money down to your neighborhood commercial bank and buy a certificate of deposit. Interest rates are low today, so the return on your investment might only be 1.0% annually; but at least your principal would be safe.
Alternatively, you could buy a junk bond through your securities broker and perhaps earn a return on your investment of 3.5% annually; however, this is a riskier investment. The company issuing the junk bonds could go bankrupt, and you could possibly lose your entire investment.
Or, you could buy for $200,000 a little commercially-zoned house that is currently leased out to a chiropractor as his office. (Important note: There is no commercial loan involved here.) He pays you $1,400 per month in rent, and he pays for his own utilities and landscaping. You're responsible for real estate taxes, insurance, and repairs. Because you hate late-night phone calls, you decide to also hire a property manager for $155 per month to manage the property for you.
Therefore, after real estate taxes, insurance, repairs, and management, you net $1,000 per month. That's $12,000 in net rental income per year on an investment of $200,000. In other words, the return on your investment is 6%. (Once again, please note that there is no commercial loan here.)
A cap rate is simply the return on your investment if you buy a commercial property for all cash. In other words, think of a cap rate as the "interest" you would earn if you bought a commercial building for all cash.
Every commercial property is different. Some commercial buildings are so attractive and are so well-located that most investors would "lust" to own them. Other commercial properties are more bread-and-butter properties, with no distinguishing appeal. Finally, some commercial properties look terrible, are in need of repair, and are located in crumby neighborhoods. Yuck. Therefore when you go to sell commercial properties, the cap rate will be different for each one.
Property 2 also generates $50,000 in net rental income. Unfortunately Property 2 is a huge, old, rusting, steel-skinned industrial building located in the flatlands of Oakland, where drive-by shootings are an almost nightly occurance. To get to the property to collect the rent, the property owner is literally taking his life in his own hands. It might take a cap rate of 12% to sell this property. Fifty thousand dollars divided by a 12% cap rate produces a likely sales price of just $417,000.
Property 3 is a cute, little five-plex in the Chinatown area of San Francisco. Demand for apartments within walking distance of Chinatown (many Chinese immigrants do not own cars) is immense. If there were ever a vacancy, a new tenant could be found in twenty minutes or less. Such a commercial property is highly desirable, and an investor might be satisfied with a 3.5% cap rate (3.5% "interest") in order to own this building. Fifty thousand dollars in net rental income divided by a 3.5% cap rate produces a likely selling price $1,428,000.
Therefore we have three different commercial properties, each producing exactly $50,000 per year in net rental income ("interest" on the buyer's investment), with three greatly different sales prices. The yucky industrial building might only be worth $417,000. The average office building was worth $625,000. The nice, well-located apartment building was worth a whopping $1,428,000 - more than $1 million more than the ugly industrial building producing the same amount of net rental income!
We'll explore cap rates further tomorrow.
Brick Building Photo Attribution: Joe Mabel