A client of mine from Atlanta called me last week, and he expressed an interest in buying another property through me. He reported that he and his family have been thoroughly enjoying their rustic, mountain getaway; they spend every weekend they can in Highlands, sometimes stretching those weekends into 4 days.
He said that he feels (and that some say looks) ten years younger and is thrilled that he and his daughter can spend time exploring the woods and discovering new hiking trails, like he did when he was a young boy.
In the couple of years he has been a home owner in Highlands, he has noticed the ever-increasing vibrancy to the downtown and the increased number of visitors throughout the year. He remarked to being a bit surprised that Highlands doesn’t seem to have as much of an “off season” as before and could see that the time was now to jump back into the market and make another investment.
He and I began discussing different commercial real estate buying opportunities. Each had compelling attributes, charm, and potential for garnering passive income. When it came time to move from discussing surface appeal to having a deeper understanding of the numbers, I stepped him through a cap rate analysis.
So what is a cap rate?
Cap rate is short for capitalization rate. Capitalization rates are an indirect measure of how fast an investment will pay for itself. Cap rates provide a tool for investors to use for roughly valuing a property based on its Net Operating Income. How do you determine cap rates?
Cap rate is calculated by dividing the Net Operating Income (NOI) by the sale price. So if you take your gross income generated by the property, subtract all normal operating expenses, excluding depreciation and loan payments, you get your NOI. Divide this NOI by the sale price and you have a cap rate expressed as a percentage. Stated as an easy formula: Cap Rate = NOI/Sale price.
And what is considered to be a good cap rate? The answer is it depends. Cap rates vary depending upon on the property, stability of tenant, length of lease, location, etc. Remember the cap rate is just a quick “curb appeal” measurement. Generally speaking, if we are in a cap rate range of 5% – 7% or more, the property warrants further investigation.
Once we have calculated cap rates, if we are still a go, we turn things over to the Buyer’s preferred financial advisor for a more detailed analysis of the property, including perhaps determining its internal rate of return (IRR). The IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments. Once this data is in hand, we may consider all the elements of the investment decision and proceed accordingly.
There are many, compelling commercial investment opportunities available in the Highlands area. And as our market growth increases and strengthens, wise investors are now considering buying options while selection is still diverse and prices are competitive.