If you're a commercial real estate investor (or aspire to become one), here's a key metric to keep in mind: capitalization rate (or "cap rate" to its friends). It shows the relationship between the Net Operating Income of a property and its overall value.
Let's say an office building sold for $20 million with an established net operating income of $400,000 a year. (Think of NOI as just pretax profits in running the building after all of its operating costs). So the capitalization rate in this case would an enormously expensive 2%. That is, the buyer paid $20 million for $400,000 in operating income...or 50 times that rate. Crazy expensive.
Cap rates exist as a vehicle with which to compare property investments. However, the cap rate alone doesn't tell the whole story. In most cases, the location of the building, its occupancy rate, the cost of debt on or attached to the building matters a lot.
The crazy cap rate of 2% that we talked about before might be cheap if the building was only half rented and the buyer was about to raise rent 30 percent on the existing tenants and bring in 30 more renters to "overnight" make NOI closer to $5 million than the $400k at which the building was running.
Cap rates represent a standard pricing metric in the industry. Think of the figure as analogous to the price per square foot in residential real estate. You could also use cap rates to look for trends in the commercial real estate market. If cap rates are going down, it most likely means values are going up, and if cap rates are going up the trend might be headed to lower market values.
Related or Semi-related Video
Finance: What is Market Capitalization v...171 Views
finance a la shmoop- what is compounding value or compounding interest? ah the
power of compounding. it makes trees stronger pollution more feral and the
rich well richer. how so well let's start with compounds kissing
cousin with six toes, arithmetic compounding. right so the first was [feet with six toes pictured]
really geometric compounding now we're talking about arithmetic compounding. if
you invest a thousand bucks in a ten-year bond that pays 6% of a year in
interest, the dough comes back to you in a pattern that looks like this - like
every six months they pay thirty bucks and it's $60 a year, got it? nice. you get
the total of sixteen hundred bucks back from your investment and the cash that
came back to you you know came in small parts all along the way, until you got [list of yearly returns]
about two thirds of it or sixty percent at the end right? if you just spent that
money and collected your thousand bucks at the end that's it. okay so that's
arithmetic compounding/ the money comes to you if you don't reinvest it.
ding-ding-ding that's the key here and you just go buy burgers. okay so now
let's look at what six percent compounded looks like over the same
10-year period .well at the end of year one it's a thousand sixty bucks and note
we're only gonna compound it annually we probably should do the semi-annually but [list of yearly compounds]
we'd confuse you even more so don't do that. but then you essentially reinvest
that money and you get another six percent compounded on that thousand
sixty , instead of six percent compounded against the original thousand. so by the
end of year two you'll have a thousand one hundred twenty three sixty. and by
the end of year ten you'll have one thousand seven hundred and ninety
dollars and eighty-five cents. so why do you make so much more money when you
compound interest versus getting 30 bucks twice a year like you would in
this bond example? go and find burgers with it? yeah .you don't want to do that
well essentially what's happening is that you're delaying your gratification [man in a drive through window]
of getting that sweet sweet cash or getting liquid whatever you want to call
it. by reinvesting your gains year after year after year. so do you have that sort
of self-control? do you need the cash yeah that's the question if you for
example have trouble making it home from your local pizza spot with the pie
in tact well then compound interest keeping the discipline to not spend the [man eats pizza while driving]
money today and wait for the happiness tomorrow well when that may not be for
you. sorry
Up Next
What is recapitalization? Pay attention the first time, there won't be a recap.