There are several different ways you can determine the market value of a commercial property, and there are several different ways to analyze whether an investment property you've sold was a successful investment or not. Terminal cap rate is a metric that can help you do both of those things.
With that in mind, here's a rundown of what terminal cap rate is, how it can help you with commercial real estate investing, and how to calculate it.
What is a cap rate?
A capitalization rate, also known as a cap rate, is a metric that relates a property's net operating income (NOI) to its market value. Specifically, cap rate is NOI expressed as a percentage of a property's price or market value.
As an example, let's say you paid $10 million for an apartment building that generates $500,000 in annual NOI. This would make your cap rate 5% ($500,000 divided by $10 million).
Cap rates are useful in several ways, but the most common uses have to do with determining the valuation of a commercial property. For example, by knowing the market cap rate for a certain property type, you can get a sense of whether an investment opportunity on the market is listed for a reasonable price or if it's too expensive.
The example we just mentioned -- calculating cap rate based on purchase price for a property you just acquired -- is known as the "going-in cap rate" and is generally based on a property's projected NOI for the first year of ownership and the actual price paid for the property.
It is also possible to calculate a property's cap rate at any given time using current NOI and market value information. And for the purposes of selling a property, using a version known as the "terminal cap rate" can be helpful.
Before we move on to terminal cap rate, it's important to point out that net operating income isn't the same thing as the cash flow or income stream generated by a property. Specifically, net operating income is how much a property earns after accounting for your operating expense. It does not take debt repayment, or mortgage payments, into account, so if you have a mortgage on the property, your cash flow and NOI are going to be two very different numbers.