What's a Cap Rate?

Lately business owners who want to buy have been asking me about capitalization (or cap) rates.

What is it? What does it mean?

Basically it is just one of many methods to assign real estate value. It can be confusing, because it is not interest. Rather it is a rate of return. According to Modern Real Estate Practice in Illinois, This rate of return is called a capitalization (cap) rate that compares the relationship of net operating income to the sales price (Galaty, Allaway, Kyle, page 389).

So what does it mean to you. It's an indication of the property value. As a buyer, you want to buy at a higher cap rate. The seller wants to sell at a lower cap rate. The common calculation is to take the Net Income divided by the cap rate and get the property's value.

Net Income
----------- = VALUE
Cap Rate

Seller's not willing to pay the commission?????

OK. So you've been working with a good commercial real estate broker. You trust them. You seem to have a good handle on real estate and find an investment where the seller is not willing to pay your broker's commission. What to do?

Remember, everything is negotiable, including who pays your broker's commission. It's not something to run from. It's just the sellers first negotiating tactic. So negotiate. Whatever the local commission rate is for your area, the seller's broker should split it with the buyer's broker.

Nevertheless, there may be an absolute refusal on part of the seller. Well, what does that mean to you? If you have become real estate savy, you may do well on your own. Yet, the average business owner is focused on their business, not the business of real estate.

As such, you might consider paying for your broker's real estate expertise by paying their commission rate. It's important to realize your broker has the ability to analyze not only your particular investment, but the local market as well. Analyzing available options, understanding the market and economic outlook will support negotiating the best possible transaction that brings value to you, the business owner.

The Landlord

Whether you are buying or leasing, the landlord can be quite intimidating. No Fear. There is way to much space available for the small business owner to choose from.

I just met a small business owner that was being pressured by the landlord to sign a lease without ownership approving the space plan. Bad Idea. If your particular business requires some kind of special plumbing or electricty, say for a kitchen or IT servers, please do yourself a favor and walk away from the deal. It's better to open late, than get yourself in a legal bind because you've signed a lease where the space no longer works for you.

And, if you find yourself in that position, please do not hesitate to call a qualified local commercial real estate broker and find out what your options are. Options. That's the name of the game. I'd bet you a swanky dinner , if that landlord knew the small business owner had other options, they'd be way more amenable.