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There are several different ways you can determine the market value of a commercial property, and there are several different ways to analyze whether an investment property you've sold was a successful investment or not. Terminal cap rate is a metric that can help you do both of those things.
With that in mind, here's a rundown of what terminal cap rate is, how it can help you with commercial real estate investing, and how to calculate it.
What is a cap rate?
A capitalization rate, also known as a cap rate, is a metric that relates a property's net operating income (NOI) to its market value. Specifically, cap rate is NOI expressed as a percentage of a property's price or market value.
As an example, let's say you paid $10 million for an apartment building that generates $500,000 in annual NOI. This would make your cap rate 5% ($500,000 divided by $10 million).
Cap rates are useful in several ways, but the most common uses have to do with determining the valuation of a commercial property. For example, by knowing the market cap rate for a certain property type, you can get a sense of whether an investment opportunity on the market is listed for a reasonable price or if it's too expensive.
The example we just mentioned -- calculating cap rate based on purchase price for a property you just acquired -- is known as the "going-in cap rate" and is generally based on a property's projected NOI for the first year of ownership and the actual price paid for the property.
It is also possible to calculate a property's cap rate at any given time using current NOI and market value information. And for the purposes of selling a property, using a version known as the "terminal cap rate" can be helpful.
Before we move on to terminal cap rate, it's important to point out that net operating income isn't the same thing as the cash flow or income stream generated by a property. Specifically, net operating income is how much a property earns after accounting for your operating expense. It does not take debt repayment, or mortgage payments, into account, so if you have a mortgage on the property, your cash flow and NOI are going to be two very different numbers.
Terminal cap rate and why it's important
The terminal cap rate, or terminal capitalization rate, of a property is the expected net income for the year it's sold divided by the property's sale price or terminal value. This is also known as the exit cap rate, or simply as the terminal rate.
Terminal cap rate is important for a few reasons. For one thing, it can help determine if you made a profitable real estate investment. Remember that property values and cap rates have an inverse relationship, meaning when cap rate is lower, a property value is higher. So if your terminal cap rate is a significantly lower cap rate than your going-in cap rate, it can be an indicator of a profitable property investment. Conversely, if your terminal cap rate based on the property's resale price is a higher cap rate than your going-in cap rate, it could mean market conditions for that particular type of commercial real estate deteriorated during your holding period.
Also, by knowing the industry average cap rates (CBRE publishes a semiannual cap rate survey that's very useful), you can determine how much you should be able to get for your property. For example, if your property generates $100,000 of annual NOI and the market average cap rate for that type of property is 6%, dividing the NOI by the percentage (0.06) shows that you should expect a market value of roughly $1.67 million.
Example of calculating a terminal cap rate
From a mathematical perspective, the formula for calculating terminal cap rate is a rather easy one:
When performing cap rate calculations (or any other real estate metrics), remember to convert percentages to decimals. In other words, 8% would be 0.08 for calculation purposes.
So let's say an investor owns an office building that's expected to generate $750,000 of NOI for 2020. If the building sells for $11 million, we would calculate its terminal cap rate as such:
The Millionacres bottom line
Terminal cap rate can be a useful metric for determining the approximate market value of a commercial property or for assessing the success of an exited commercial real estate investment. Be sure to add it to your real estate investing toolkit.
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