Cap Rates are an easy way to quickly assess if a property makes sense. Before going into details; I know (at the time of this post) that a 4.12% cap rate is the essential break even on a property based on “today’s” mortgage rates.
Right now the average 5-Year Term commercial mortgage is an a 25 year amortization with an interest rate of about 4.45%.
We will come back to this shortly. First, let’s look at the basic math behind a cap rate.
Simply, it’s when you divide the NOI (Net Operating Income) by the purchase price. As mentioned; the mortgage payments are not calculated in your NOI (See the article on NOI).
If the NOI of the property you are interested in purchasing is $100,000 and the purchase price is $1,000,000; the cap rate is 10%. Let’s assume you are buying this with no mortgage. You have $1,000,000 at your disposal (plus closing costs). How long will it take you to recapture your $1,000,000? At a rate of $100,000 NOI; in 10 years you will recapture what you spent on the building.
$100,000 (NOI) x 10 years = $1,000,000.
Let’s use the same NOI and perhaps change the purchase price. Let’s say the purchase price is now $1,650,000. What is the cap rate?
The same equation is used; divide the NOI by the purchase price.
$100,000 / $1,650,000 = 6.00% Cap Rate.
Similarly; it would take 16.5 Years to recapture that purchase price.
Remember, cap rates are only as accurate as the information you have available to you. You MUST have an accurate Net Operating Income (Gross Income Less Expenses equal Net Operating Income).
Quickly, your NOI is calculated as follows ($145,000 – $45,000 = $100,000.):
Gross Income: $145,000
Operating Expenses: -$45,000 (not including mortgage payments)
Net Operating Income: $100,000
Now back to how I mentioned that I know by looking at a cap rate, and with the knowledge of what current interest rates and terms are; I know what the Break-Even point is. Let me show you.
- Price: $1,000,000
- Net Operating Income: $42,000 (annual)
- Cap Rate: 4.20%
Right now, the buyer is well qualified by the bank and meets all lending criteria for a purchase of this scale. Right now the current interest rate is 4.45% on a 5-Year term and 25 Year Amortization.
Being commercial, assuming he has to put 35% down payment ($350,000) and will be financing the 65% balance ($650,000) from an A-Lender (major bank).
The mortgage payments for this property would be: $3,579.53 per month. When annualized the mortgage payment ($3,579.53 x 12 months). Your annual debt service amount is: $42,954.36.
This is almost $1,000 per year that the buyer would have to spend out of pocket to maintain. Now there are some buyers who would be fine with that such as developers but that is another article for another day.
If you have any questions about this feel free to contact us 🙂