In this article
- Cap Rate
- Vacancy Factor
- Example Using the Vacancy Rate
- Net Operating Income and the Vacancy Factor
- We Can Help
Commercial real estate investment is a popular form of investment that has been around for many years. It offers the potential for high returns on investment, long-term capital growth, and the opportunity to diversify one’s portfolio. However, investing in real estate requires a good understanding of the market and the ability to analyze properties effectively. One critical metric that real estate investors need to understand is the cap rate.
The cap rate is an essential metric used in commercial real estate investment that represents the rate of return on investment that a buyer would receive if they purchased a property in cash. Essentially, it is the ratio of net operating income (NOI) to the property’s purchase price.
You need to input the purchase price and potential gross income to calculate the cap rate. The potential gross income is the total income the property could generate if fully occupied. For example, if a building currently generates $200,000 in revenue but has the potential to generate $250,000 if fully occupied, the potential gross income would be $250,000. This benchmark is useful when comparing different properties as long as you compare potential gross income for similar properties.
The term “vacancy factor” refers to the percentage of a currently unoccupied building, with a minimum percentage typically factored in.
When investing in real estate, it’s crucial to consider the minimum vacancy rate in the area when underwriting a deal. For instance, a minimum vacancy rate is typically factored in, with the bare minimum being 5% for multifamily properties and possibly higher for other types of assets.
When underwriting a deal, it’s essential to determine both the actual vacancy rate and the required minimum rate and ensure that the minimum vacancy rate is included in your calculations.
EXAMPLE USING THE VACANCY RATE
To better illustrate this, let’s take the example of a building with a potential gross income of $250,000. If the current income on the property is only $20,000, there is a 20% vacancy rate or $50,000 worth of potential income that is not being realized.
Therefore, the vacancy factor would be 20%, representing the percentage of the vacant building. In another example, consider a commercial building with a potential income of $250,000, but currently, it only generates $225,000, indicating a 10% vacancy rate. This means that the vacancy factor is 5%. This is calculated by taking 5% of the $250,000 potential income, or $12,500.
It’s worth noting that, in most cases, the actual vacancy percentage is factored into the equation.
At GPARENCY, we provide real estate investors with a catheter that allows them to input actual and adjusted numbers for underwriting purposes. Using these figures, we can calculate the effective gross income by subtracting the vacancy from the potential income.
This figure is essential when underwriting a deal for cash flow purposes to determine if there is sufficient income to cover all expenses. Essentially, the effective gross income represents the net cash flow after accounting for underwriting and vacancy, which is considered the gross income on the property.
NET OPERATING INCOME AND THE VACANCY FACTOR
When analyzing a property for investment, it is crucial to calculate the net operating income (NOI). This is obtained by subtracting the annual expenses from the effective gross income. NOI is the standard operating and underwriting metric used for GAAP (generally accepted accounting principles) in the real estate accounting world. It is the universal language for determining the profit of a building or property.
To properly underwrite a deal and arrive at the right NOI, several factors must be considered. here are the factors that need to be considered when determining the right Net Operating Income (NOI) for commercial real estate investment:
- Gross potential income
- Vacancy and collection losses
- Operating expenses
- Capital expenditures
- Other income and expenses
- Debt service (if applicable)
All of these factors are important to consider in order to accurately determine the NOI, which is a critical metric in evaluating the potential profitability of a commercial property investment.
The expertise in underwriting comes from knowing which expenses are appropriate for a specific building, as different professionals use different ratios. Once the NOI is established, it becomes the baseline for all further calculations. The cap rate of a building, for example, is based on the NOI in relation to the purchase price, while the debt service coverage ratio is based on the NOI and the payments to the bank.
In conclusion, understanding the fundamentals of commercial real estate investment analysis is crucial for making informed decisions and maximizing profits. The cap rate, vacancy factor, effective gross income, annual expenses, and net operating income are key metrics that every investor should consider when analyzing a potential investment property. By carefully underwriting a deal and accounting for all expenses, investors can accurately determine the profitability of a property and make informed decisions. With the right knowledge and tools, commercial real estate investment can be profitable for anyone willing to put in the effort and diligence to succeed.
We Can Help
If you’re a commercial real estate company, The GPARENCY CRE Marketplace platform can be beneficial during a recession because we provide a transparent and efficient way to manage and track commercial real estate investments. Our platform is the perfect commercial real estate network for investors.
You can access real-time data and analytics, identify areas of potential risk, and make informed decisions about your investments. Additionally, the GPARENCY commercial real estate platform can help investors save time and reduce costs associated with managing their real estate investments, which can be especially important during times of economic uncertainty.
Overall, the GPARENCY CRE commercial real estate network platform can help investors navigate the challenges of a recession and maximize their returns on commercial real estate investments.
- What is a typical range to estimate for the vacancy factor?
- In commercial real estate, the estimation for a vacancy factor typically ranges from 5% to 10%. However, it ultimately depends on the location and type of property.
- Why is cap rate important to determine before investing in commercial real estate?
- Cap rate is an important metric to determine before investing in commercial real estate because it helps investors understand the potential return on their investment. Cap rate, short for capitalization rate, is the ratio of a property’s net operating income to its purchase price. By knowing the cap rate, investors can compare the potential return of different investment opportunities and determine whether a property is overvalued or undervalued. Additionally, cap rate can help investors assess the risk associated with a particular property and make informed decisions about whether it aligns with their investment goals and financial strategy.
- What is the effective gross income?
- Effective Gross Income (EGI) is the total amount of income that a commercial real estate property generates after subtracting the vacancy rate and accounting for other rental losses such as concessions and bad debts. It is the income that the property owner can actually count on receiving during the year. EGI is an essential metric for determining a property’s overall profitability, as it helps to calculate the net operating income (NOI) and the property’s overall value.