Eighty percent of investors who call Westwood Net Lease Advisors about making a property investment start the conversation by inquiring about the capitalization rate (a.k.a. cap rate) they desire in a property. While the cap rate for a property can indeed be a predictor of its future worth, it is important to realize that cap rate is a guideline and not the sole determining factor of whether an investor should buy one commercial real estate property and not another.
CONSIDERATIONS IN ADDITION TO CAP RATE
The cap rate of a property is a popular measure of its value for two reasons:
- The concept of cap rate is easy to grasp (i.e., the ratio between the net operating income of a property and its capital cost).
- A property’s historical cap rate is easy to extrapolate to predict its future income.
Even so, it is important to consider other factors that are just as indicative of a property’s worth.
The following components are also essential to examine before investing in a property.
- Rent per square foot (is the rent high, low, or average for the area?)
- Average annual population growth of the 1-5 mile radius surrounding the property
- Average household income for the 1-5 mile radius surrounding the property
- Tax incentives provided by the city or state in which the property is located
- Quality of neighboring tenants (e.g., big box retailers versus small businesses)
- Location in relation to major streets and intersections
- Internal rate of return (IRR) based on your tax bracket and deprecation benefits
- Ability of the tenant to gain a long-term, low-interest loan
The cap rate of a property is important for predicting its value, but it is essential for investors to see cap rate as what it is: one of many factors that help investors and property brokers determine the prospective value of a property.
Note: Before you move forward with a real estate investment, it is recommended that you hire a real estate attorney and a CPA to oversee the legal and financial aspects of the deal. Having these professionals on your side will help you complete the transaction in an accurate, timely manner.