In my previous career, many of us were avid stock traders. I was an Engineering Manager in a local high tech company and we fancied ourselves as having some level of insight into our clients fortunes.

Being luckier than most, through a series of unexpected events I managed to cash in most of my chips before things got ugly and high tech had its melt down.

Now in Commercial real Estate I find many people who are comfortable with the stock market are not yet comfortable with Commercial Real Estate.

My intent with this article is to give the person who is familiar with analyzing a stock a better idea of how to apply the same principles to analyzing investment real estate. The differences are mostly semantic.

At the top level, Commercial Real Estate is characterized by the Capitilazation Rate. This is the ratio of Net Operating Income (NOI) to Purchase Price as expressed here:

Cap Rate = NOI / Purchase Price.

It helps answer the question, "If I bought the building for cash, what is my annual return"?

Similarly, when we look at stocks, the first ratio we talk about is often the P/E ration or the Price to Earnings Ratio. This helps us answer the question, "What did my share (as represented by your share of stock) of the company earn this year"?

So,  if you are accustomed to thinking about stocks in terms of of the PE ratio, then think of the Cap Rate as the reciprocal of the P/E ratio.

Example - In Pinellas county, nice office buildings are trading at an 8% Cap Rate (e.g. a $1,000,000 building with a Net Operating Income of $80,000 per year). This would be considered a conservative investment. And right now Caterpillar stock (A solid Dow Jones Industrial stock) is trading at a P/E ratio of 13.36 (We can buy 13,939 CAT at  shares at $71.74 with our $1,000,000 and this share of the company earns about $74,850)

1 / 13.36 = .075 or 7.5%. As you can see, these two investments of relatively similar risk and show similar earnings compared to their purchase prices.

Now for a couple of clarifying points, Dividends are a different thing - I will address them in another post. And Cap Rates do not include any mortgage calculations. The NOI only addresses the buildings financial performance as if it were purchased for cash.

These calculations do not address how much money you will put in your pocket with these investments, but they allow us to compare one building to another, or one stock to another, or stocks to Commercial Real Estate.