cap rate in commercial real estate

The capitalization rate, also known as cap rate, is used in commercial real estate investing as an important metric for determining the rate of return that a potential investment property can generate. Diligent investors consider any investment’s profitability and return potential through a pro forma financial projection of the investment using this metric. However, real estate professionals should not rely solely on this for analyzing an investment’s potential. This is because it does not take into account the time value of money, mortgage, and future cash flows among other factors.

In this blog, we will explore cap rates, their uses and limitations, their formula, and what a good cap rate is.

What is Cap Rate?

A capitalization rate of commercial real estate property is the estimated rate of potential return on investment that an investor expects to receive.

Therefore, it represents the income of the property over one year. It assumes that an investor has purchased the asset on cash and not on loan. As a result, Cap rates generate an equal rate of return that excludes the interest rates of the loan repayment.

Hence, this measure indicates an asset’s unleveraged, natural rate of return.

How is the Capitalization Rate used? 

Cap rate is essentially a measure of risk. Whether the property is in a desirable location or has the potential to attract quality tenants and higher rents. Therefore, riskier investments generate higher cap rates due to their lower correlation with the market conditions. 

So, generally real estate investors aim for a more modest cap rate of 4-5%. This is ideal as it involves much fewer risks and a higher sales price.

So, lower cap rates signify a lower risk and a higher purchase price. On the other hand, a higher cap rate means a higher risk.

However, an investor can use it to compare the value of an asset with other similar properties that have traded in a given market in the last 6 months. On the other hand, buyers can determine whether they are getting a fair price on the deal.

Similarly, brokers and sellers can use this tool to project an asset’s potential income and expense ratio to interested buyers.

Investors and property managers can use Cap rates for various types of commercial and residential property types. These include multifamily rental properties, single-family rental houses, and other commercial real estate assets. In some cases, cap rates can also evaluate the time required to recover the initial investment.

How to calculate cap rate?

Investors can calculate the cap rate on a commercial asset by dividing its annual net operating income (NOI) by its current market value. It is expressed as a percentage. So the formula for the cap rate calculator is:

Capitalization rate = net operating income/current market value

Where,

Net operating income (NOI) is the annual income that remains after deducting all its operating expenses.  If you rent the property then your NOI would be the annual rental income minus the maintenance costs, property taxes, and other associated costs.

The current market value of a property is the present value of the asset according to the prevailing market conditions.  This value varies depending on the features of the property, supply and demand, and the overall real estate market conditions.

It helps in evaluating commercial real estate investment in different asset classes, sizes, square feet meant for rent or unit mixes.

The cap rate is a no mortgage return of an asset.  If a buyer decides to purchase the property in cash and if the property distributes the same NOI then the buyer must receive a return of 7% on their investment. Cap rates are a risk measurement. If it has a low cap rate of III – 5% then the asset has lower risk and higher value but a good cap rate of 8 – I0% denotes a lower price, higher risk, and higher return.

What factors impact the Capitalization Rate?

Before making decisions on investment properties and leveraging cap rate it’s important to go through the factors that affect it. These include:

  1. Property type – 

There are six different types of investment property: agriculture, residential, commercial, industrial, mixed-use and properties that are used for special purposes which are further categorized by property characteristics. Commercial properties consist of office spaces, shopping malls, hotels, etc. Therefore, each property type entails different risks, expenses, and potential returns – all of which are proportional to their cap rate.

  1. Property value – 

Real estate investments have different cap rates depending on their position. Real estate in cities tends to have a higher cap rate whereas the cap rate is lower in small cities or towns.

In urban areas, the economic status is diverse and seems to be more stable than the investment opportunities in rural counterparts. In big cities, the rents are higher and it draws prospective tenants. Hence, it increases the cap rate. 

But, on the other hand, in semi-urban areas and countrysides, both the rent and cap rates are low. 

Comparative properties within a locality or radius, also affect the cap rates of a particular asset. Properties of a town or city are divided into A, B, and C classes. Class A buildings are referred to as the highest quality based on their location with a lower cap rate since they are valued higher.

  1. Rental Potential-

A property’s features not only denote its value but also conveys its desirable features. If an asset has high vacancy rates, it generates no income and eventually turns into a financial liability.

Moreover, the prevailing supply and demand of assets in a given real estate market also impacts the potential of an investment in that particular market. Thus, all of these features impact the leasing potential and cap rates of a property.

What is a good cap rate for commercial real estate assets?

A 5% cap rate may be considered as a ‘good cap rate’ for class A office buildings in large metropolitan areas like San Francisco or Manhattan. A good cap rate for Class A office buildings in Tier I markets like Boston or Washington will be better than the good cap rates for Class A office buildings in Tier II markets like Philadelphia and Austin for Tier III markets like Indianapolis and Kansas City. 

Therefore Tier I assets have lower cap rates compared to Tier II and Tier III market assets.

On the other hand, good cap rates for Class B office buildings can range anywhere between 6.75% to 8%.

Similarly, opportunistic class C properties will have lower cap rates for downtown office properties as compared to Suburban office properties in a particular metropolitan area.

Final thoughts

In the end, we can sum up by stating that capitalization rates only help us to estimate the potential of property investment. However, since it takes only two variables into account – the property’s NOI and the current market value, cap rates are based on estimates, not guarantees. Before applying this metric to your investment, you should be clear about all the consequences. You should consider this rate as a guide for how, where, and when to invest in real estate rather than taking the final decision for a financial agreement.