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In the last episode we learned how to save searches for properties for sale in your area on loopnet.com and you also created an account on biggerpockets.com in order to start reading some blog posts and meet real estate people in your area. In this episode, we will be learning what is a cap rate and what you should be looking at when you see a notification from Loopnet that a new property is available for sale in your area.

What is a cap rate?

A cap rate is a variable rate that varies per property, and is determined when you are selling the property. As a buyer, you will be looking at various cap rates, and the very basic explanation is that it is the net income on the property divided by the price of the property. For example, there is a property for sale for $400,000 and the cap rate is 8% – this means that your income on the property is $32,000 per year. There are other intricacies about cap rates when you are selling the property, but what you need to know is that cap rates can vary greatly. For example, it depends on the location of the property, in California you’ll find cap rates of around 4- 5%, and are there others states you may find cap rates of 8, 9, 10, 11%.

Cap rates also vary based on where the property is located in a particular city. If the property is in an incredible location, the cap rates are going to be lower, if the property is leased to a national tenant (for example Starbucks, Burger King), the cap rate will still be even lower because your rent is going to be guaranteed and you can easily sell this property. However, when you have a local tenant, and the property is not in such a great location, or is the location isn’t very visible, then your cap rate can be higher because the seller is incentivizing you to buy the property.

Cap rates are also determined by the interest rates on loans: when interest rates are low your are able to lend more money to buy property – meaning you qualify for a higher mortgage – however, when interest rates are higher, you can afford less property because you’re getting a smaller loan. You need to look at all of these things not only when you’re buying, but also when you’re selling a commercial property because when you’re selling that’s when it’s going to determine what the cap rate for the property is.

To elaborate more on cap rates varying by location: for example here where I am in California you can find cap rates as low as 2.5% in Santa Monica which means that you’re making a 2.5% income per year based on the price of the property. You can also find 7% cap rates in some areas of Berkeley for instance. However, in Alabama, you can find cap rates at 10% and that’s because it’s harder to sell the properties there than in California, so the sellers typically want to make the rate pretty attractive to the buyer.

When you’re looking into buying a property, you want the properties with the highest cap rates as possible, but there are situations where that’s not really the case, and we will cover those details in another episode (for example, you find a value add property where rents are currently low – the cap rate may be low when you buy, but you can add a lot of income to the property by managing it properly).

If you’re completely lost about what a cap rate is, fear not, it can be a bit complicated! In a future podcast I’m going to be breaking it into two separate areas: 1. What is a cap rate and how should you determine what a cap rate is when you’re selling the property and 2. What does a cap rate mean when you are buying the property. But, if you haven’t understood it yet, the basics of it is: when you’re buying a property the cap rate is the net income that you’re making on that property / the price of the property, so for example, if you’re buying a property for $1,000,000 and your cap rate is 10%, your net operating income as $100,000 – it is the money you’re making every year on the property divided by the price of the property. Hopefully this makes it pretty clear to you on what a cap rate is.

How do you evaluate a commercial property for sale at first glance?

Now we’re going to go and take a look at a property that is available for sale on Loopnet. By now you should be getting email alerts from Loopnet on properties that are for sale in your area, so let’s open one of those emails and click on one of the properties in your area. I’m looking at a property I found in the city of Redwood City and it’s for sale at $825,000 which is pretty affordable here in the Bay Area, let’s scroll down, I see that the property type is retail and the property subtype is storefront retail / residential. I’m not particularly interested in managing residential tenants that are living in a property, but let’s find out more about the opportunity. Under the description is says “rare stand-alone building on Woodside Road. Two-story mixed-use building can be easily divided into three bedroom apartment upstairs and office / retail underground”. So this property has a retail component on the ground floor, and on the top floor it can be a three-bedroom unit that I could rent out. It sounds interesting to me because it’s in a very good city and I could potentially get at least $3,000 for rent upstairs, but I’ll have to do some research on what I could get for the lease for the downstairs retail unit.

Below the pictures I’m looking at the gross leasable area, 1,566 sf, now I can do a very quick calculation to see the price per square foot for the property. So that’s $825,000 / 1,566, the price per square foot is $526. This is a good price considering that we are in Silicon Valley, for you to have an idea, in the city of San Francisco a typical price per square foot can be around $1,000, this property is a few miles south of San Francisco, so this is a pretty standard price per square foot. This building has two stories, it was built in 1940 and there is a parking ratio of 1.92 per 1,000 square feet (a good parking ratio is 4 spaces per 1,000 sf. I see the APN / parcel ID number of the property, and it gives me a walk score of 79 (very walkable), this means it’s in a pretty decent neighborhood where people can walk down the street and it’s safe. As I keep scrolling down there’s not much more information besides “great visibility” and under “sales notes” it shows us when they’re having an open house. Now that I know the total square footage, I know how much I’m paying per square foot, this means that the unit upstairs is probably 800 sf and the unit downstairs is also 800 sf, I have no idea how a three-bedroom can fit in 800 sf, but we’re going to have to take a look at this property in real life.

On the right side of the pictures, you’ll see the map, what we’re going to do is click on this map and once you’re there, you’re going to click “street view” and you’re going to drag the arrow up and down this street in order to see what the neighborhood looks like (thank you Google). I see a Wells Fargo near this property, I see a dry cleaner, I see a US Bank, and note that the dry cleaner could be a red flag because there could be contamination on the grounds of the property. A contaminated property is very expensive to clean and the city will make you clean up the site – and if it’s not the clean it could ding the value of the property later when you’re trying to sell it.

By now I’m taking mental notes to ask the real estate agent how big the unit upstairs is, how big the unit downstairs is, how could it be that there is a potential 3 bedroom upstairs, and is this property contaminated or not. I’m also going to ask him if a “Phase I” report has been done, this is an environmental report that costs around $3,500-$4,000 that you need to get done in order to see if the property is contaminated or not. Sometimes sellers do that report in advance, and sometimes you’re going to have to pay that out of pocket when you’re doing the due diligence  after your offer is accepted. Now you have a very basic understanding of what you should be looking for when you get those Loopnet alerts in your inbox. In the next episode, we’ll be going over the questions that we should be asking the real estate broker that is selling the property in order for you to understand if it’s a property you should pursue or not.

He did each single thing, as if he did nothing else. — Charles Dickens

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