If you’re interested in buying commercial real estate, one of the most important terms you should know is capitalization rate. The capitalization rate, or the “cap rate”, helps one determine the value of a commercial property, and knowing it is integral to the buying or selling process of commercial real estate. But what exactly is it, and how do we find it?

At its core, the cap rate is the ratio of a commercial property’s annual net operating income to its buying price. The cap rate allows one to evaluate commercial properties in varying asset classes, sizes, unit mixes, rentable square feet, or ages on the same terms. Capitalization rate isn’t used in residential real estate because homes are values based on similar nearby comparable properties that have recently sold. Commercial real estate’s value is based on the income it produces, which is why the cap rate is so commonly used. 

If you’re looking to find out what your commercial properties capitalization rate is, it’s actually rather simple. The first thing you need is the net operating income. This is your property’s annual gross income minus annual expenses and doesn’t include any debt that may be held for the property, such as a mortgage. From here, you divide the net operating income by the asking price or the current market value of the property. So let’s say your property has a gross income of $500,000 with expenses of $200,000. This would make its net operating income $300,000. If your property was then listed for sale at $4,000,000, the cap rate would be 7.5% (cap rate is typically shown as a percentage).

So why would you need to know what your cap rate is? Well, having the cap rate allows you to compare commercial real estate properties separately from the purchase price. This helps you figure out which would offer a higher return on investment, regardless of how much it may cost. When you have a high cap rate, it also allows for a higher potential return and buyers are able to compare two investments based on their capitalization rate in order to figure out which one is worth delving deeper into.

Cap rate is typically used when a commercial real estate property is being bought or sold, but it can also be used to identify an average sale value for the market at any given time. The average cap rate will vary based on different circumstances, such as property class, geographic area, asset class and location (such as suburban or rural). These average cap rates assist buyers and sellers in gauging the pricing of the overall market as well as figuring out the average valuation of their property.