All real estate appraisers use the Income Capitalization Approach when it comes to valuing commercial income-producing real estate. This approach determines the Net Operating Income (NOI) of an investment property and divides that number by the capitalization rate or “CAP Rate.” (NOI ÷ Rate = Value). That’s called the “IRV” formula where “I” means NOI, “R” means CAP Rate and “V” equals value.
Think of the “CAP Rate” as the return an investor expects to achieve based on the risk they are willing to take. The higher the risk, the higher the CAP Rate. For example, Walgreens does not own the real estate that houses its business. Investors own the real estate and Walgreens leases the space.
Walgreens is a Fortune 500 company. They are very profitable and have lots of cash. They have a very high credit rating. If you buy a real estate investment leased to Walgreens on a long-term basis, you assume very little risk because the company guarantees the lease payments. Less risk means a lower CAP Rate or return on the investment. Walgreens properties sell for about a 5.0% CAP Rate.
On the other hand, if you’re buying a retail property where the tenant is local and doesn’t have a strong credit rating or track record, the risk is much higher. Therefore, you would require a CAP Rate of 8% to 10% or higher if you were to invest in that property.
So, when investing in Commercial Income-Producing real estate, make sure you apply the right CAP Rate. A small change in the CAP Rate can have a major change in the value so make sure you don’t overestimate the CAP Rate.