Gary....I could be trite and answer this question by saying, "a cap is anything that you put on top of something, such as headwear on one's head". But, I don't think you are looking for that. This indeed is Return of Cash Investment. I believe what you are really asking is, "What is a cap rate in commercial real estate and how is it used"? If I am wrong please forgive me for providing an answer to my own formulated question.
A capitalization rate in commercial real estate is a method of determining just how much the purchase price of the property will return on an annual basis, if one pays all cash for the property. (Do not get this confused with "cash on cash" as that is usually the figure that is shown after "net operating income" has been achieved and debt service and other below the line items are deducted).
Cap rate analysis is very helpful in comparing property values one to another. It is also way of comparing a return the value of a property when all cash is paid to the value of a stock when all cash is paid; the value of savings accounts; trust deeds; bonds; and any other alternative method of investing cash.
An example of this is: You consider a purchase of a rental property for $2 M and pay all cash. Your capitalization rate is 8%. Thus, you have to receive $160,000 in Net Operating Income (NOI) annually. (Collected rents, minus all operating costs = NOI). Alternatively, you will have the opportunity to purchase a bond for $2 M that will return a 4% capitalization rate for you. The bond will provide $80,000 per year of income. It now becomes your choice to determine the risks of the bond and the risks of the real estate purchase. There are many factors to weigh in this decision besides the difference of $80,000 per year of income between the two investments. This is where investment analysis skill plays a large part. Weighing both risk and reward in the investment of a client’s funds in commercial real estate is a real necessity in the successful representation of others.
Thus, you I hope you can understand the concept of capitalization rates is a very important step in seeking to become a true commercial real estate professional. Good luck Gary.... Rob Baird, CA RE License #544165 (One of the oldest, active licenses in CA) 951 515-5855 Email: firstname.lastname@example.org
Feb 7, 2011