Real estate has been a major attraction for investors for a long time. The sector has witnessed several ups and downs in recent times and especially after the pandemic outbreak, the need to calculate the exact value of a property has become imperative. Not only investors but every potential commercial property buyer must have a basic knowledge of calculating their property value based on capitalization rate. This post will discuss the complete methodology to get a deep understanding of capitalization rate and its impact on a property, and how it can add to their ROIs.
What is Capitalization Rate?
Generally, commercial properties refer to those premises which are used for business purposes and every business has its own earning. Cap rate is used to determine the rate of return on a commercial property depending on its net income. When you divide the net operating income by property asset value or its market value and express it in percentage, it is known as the capitalization rate of that particular property. Most commercial property investors use this method to determine their actual returns on their investments. Even flats/apartments in Gurgaon are also valued based on this method only. It is mostly used for comparing the relative value of similar real estate investments.
What Importance does it have?
This is the most prominent measure to assess real estate investments to ensure profitability and returns on investment. It simply represents the value that a property has gained over a certain time assuming that the property has been purchased on cash rather than on loan. It acts as an indicator for investors to keep track of their possible returns on a commercial property and plan accordingly.
Calculating the Capitalization rate
To calculate the capitalization rate for any real estate commercial property, you will require its income and expense statements to get net operating income which is generally stored at the owner’s end. Net operating income is crucial to decide the capitalization rate of a property. But to make it clear for you let’s simplify it by assuming an example.
Suppose you have invested in a property that has a market value of 10 lakhs, and which is given for use for a certain monthly price of Rs. 10,000 per month. The annual income will be around 1, 20,000 per year and you spent 20, 000 on its annual maintenance charge and other property taxes. Now if you deduct annual gross income from maintenance charges, you will get your net income like this:
1, 20,000-20,000 = 1, 00,000.
Now assuming that your property value remains the same for the first year, that is 10, 00,000, the capitalization rate will be calculated as:
Capitalization Rate = 1, 00,000/10, 00,000 = .1 or you can say 10%
This 10% cap rate which you get for property investment is better than all such investments like in any other treasure bond which yields a maximum of 4-5% returns on your investments. It must be noted that investing in commercial properties is always subject to various risks and capitalization rates can vary widely in different scenarios.
Commercial Property Investment: The choice is always yours
Unlike flats/apartments in Gurgaon, commercial property investors use a whole new level of mathematics to calculate property value based on different aspects. Specialized calculations are used to determine whether a project has to be financed or purchased on cash depending on their goals and objectives, and on different types of properties. Investors apply different formulas based on different aspects these days to calculate their property valuation and it is advisable to be familiar with most of them to gain healthy insights into your investments.
Break Even Ratio
This another major pattern of determining the percentage of a property which must be put on the tenancy to cover all debts, expenses, and service obligations. To calculate this ratio, try the following formula:
Break-even ratio = Total operating expenses + Total debt expenses/Potential property income
So, if we put the above-mentioned condition to this formula, we had 20,000 as operating expenses and let us assume debt expenses on different loans as 10,000
20,000 + 10,000/1, 20,000 = 25%
This means you can contract for one-fourth of your property to cover all expenses and debt service obligations.
Interpreting the capitalization rate
There may different cap rates for different properties and across time horizons for the same property and the risks related to them vary accordingly. The above mentioned formula clearly states that a property with a higher net operating income will represent higher capitalization rate.
Assume that there are two similar properties with similar characteristics but are located differently. The first one is in the middle of a posh area while the other falls in the outskirts of a city. Now, the property in posh area will definitely generate higher fee income as compared to the outskirt one. But when it comes to maintenance costs and other expenses such as taxes and local government regulations, the building in the posh area will represent a lower cap rate just because of its higher maintenance costs and expenses.
This simply implies that the lower value of the cap rate resembles better valuation along with better vision of returns with the lower level risk involved in it. Whereas a higher value of cap rate implies lower return on investments with a higher level of risks. Hence, every investor has to be very tactful while making a decision based on cap rate of a property and it may not be feasible enough to make a decision merely on the cap rates.
Factors affecting the valuation of the property
As mentioned above that investors use advanced mathematics for the property evaluation but still, there are various factors that may affect the valuation of flats/apartments in Gurgaon, and depending on different aspects of a commercial property as well. Let’s also have look on them.
This has always been a deciding factor in the valuation of any kind of property whether residential or commercial. However, for residential purpose, people may prefer a tranquil location little away from main hustle-bustle. Whereas a commercial property investor will be much interested in a location which is right in-between the main city and offers good connectivity for a business purpose.
Amenities are the driving force for any commercial property as they enhance the working of any business and offer smooth functionality, making it much convenient for them to operate. Moreover, as these amenities are also a part of operating expenses incurred on a commercial property, hence, it plays an important role in calculating its cap rate also. The more amenities available with a property indicates lower cap rates.
Condition & Design
The present condition of a building is also another deciding factor for its proper valuation. The time of its construction, the level of its maintenance, and its design, all these factors can affect its value significantly. People prefer this much in buying flats/apartments in Gurgaon. The design also needs to be focused on whether it supports earthquake resistance structures or not.
Approvals for a commercial property may also vary depending on the type of structure it is and where it is located. The local government levies different taxes on real estate premises and there are ample approvals that have to be taken from them. All these factors contribute significantly to calculating the net operating income of a building.
Investing in commercial properties requires much knowledge and information on different aspects which are almost covered in this post but still investors are advised to update themselves with some other practices also which are used to evaluate a property.