12 August 2019/ sale_commercial_property

Key Terms Investors Need to Know When Evaluating Investment Opportunities

Clever calculations to help you evaluate investment opportunities

Getting to grips with cap rates, cash flow, and cash-on-cash returns will help you determine a property’s investment potential

If you’re considering investing in commercial property, there are some key investment terms that you may come across, which are well worth being familiar with. Notable ones are ‘cap rate’, ‘cash flow’ and ‘cash-on-cash return’. These are analytics that investors use to calculate if a potential commercial property is worth investing in.

Here's an explanation of what each one means.

 

Cap rate

 

A capitalisation rate, or cap rate, is a formula that investors, particularly in the US, use as a tool to help them decide if a property looks like a promising investment. It’s generally calculated by taking the rental income, deducting all non-mortgage expenses, then dividing this number by the purchase price of the property. For example:

  • Annual rental income: £40,000
  • Management, repair and insurance costs (excluding mortgage costs): £12,000
  • Net income: £28,000
  • Purchase price: £280,000
  • Cap rate: 10%

In UK terms, it's similar to net yield, but you don’t deduct the mortgage payment. Cap rate comes in handy to compare different properties as it captures the costs you’d associate with a property – such as repairs, bills, insurance costs and management costs – but takes the mortgage (a complicating factor as every investor will be using a different mortgage product with a different monthly payment) out of the equation. Essentially, cap rate provides a realistic picture of returns after operating expenses have been accounted for. Generally, 4% to 10% per year is a reasonable range to earn for your investment property.

 

Cash flow

 

The term ‘cash flow’ refers to how much cash the property will generate annually for you after all expenses are taken into consideration, including all of your loan payments.

So, if you’re looking at a £280,000 property and you put down a 20% deposit of £56,000, a mortgage of £224,000 over a 15-year period with a 4% interest rate will cost you £20,181 a year. Deducting this from the property’s annual net income of £28,000 gives you a cash flow of £7,819 a year.

 

Cash-on-cash return

 

The final step in putting all of this information together is determining the ‘cash-on-cash return’ – the annual cash flow as a percentage of the deposit you put down for the property. So, if your annual cash flow is determined at £7,819 and you paid a deposit of £56,000, your cash-on-cash return would be 13.96%.

Whenever the cap rate rises for a specific property, with all other things still being equal, the cash flow and the cash-on-cash return for the property will rise, too.

All of this then comes together with the purchase price, deposit, net income, interest rate and monthly loan repayments. To give an example of how one variable can affect the entire scenario: If interest rates were to rise, the cap rate would remain the same, but the cash flow for mortgaged properties would diminish because of the higher total annual loan payments on the property.

Knowing cap rate, cash flow and cash-on-cash return can help you determine if a property is a good potential investment. More data is always better, since you want to make the wisest decisions you can when investing in commercial property.

 

About the Author: Jim Gillespie

Jim Gillespie is the Founder and Creator of Commercial Real Estate Coaching, and he's been president of three different commercial real estate organisations. In addition, he is the author of the bestselling book, Commercial Real Estate Power Brokers: Interviews with the Best in the Business.