When you’re searching through commercial real estate listings, you’ll likely see the term, cap rate (short for capitalization rate), highlighted in each post. A cap rate is one of the most common valuation metrics used in CRE. Before you dive into investing, it’s important to understand the definition of a cap rate and how this term is used in CRE. This guide will explain what a cap rate is, how to calculate it and some common misconceptions about it.
What Is a Cap Rate?
A property’s cap rate tells an investor the amount of money they can expect to earn per year as a percentage of the property’s value. The cap rate is the net operating income (NOI) divided by the cost of the property. Buying a property with a higher cap rate will result in more earnings per dollar invested. This metric is often used to compare multiple similar properties side by side to measure their relative values.
Cap rates typically range anywhere between 4% for a triple-net lease from an investment-grade tenant to 10% or above for riskier investments. Investors taking on higher amounts of risk will expect higher returns, leading to higher cap rates.
Sample Cap Rate Calculation
Here is the formula for cap rate:
Cap rate = net operating income (NOI) / property’s market value or sale price
For example, if a property is worth $500,000 and its NOI is $50,000, this would result in a cap rate of 10%.
To complete this formula, you’d first have to either find or calculate the NOI, which is the gross operating income minus the operating expenses.
What Does a Cap Rate Tell You?
A cap rate will tell you how much a property will earn per year relative to its cost.
- A higher cap rate: A high cap rate typically comes with more risk. For example, an older property that requires renovation will cost less than a newer property; the older property is likely to have a higher cap rate.
- A lower cap rate: A lower cap rate typically indicates that a property is more stabilized. The property may be in top condition or recently renovated and therefore will have a higher value, bringing the cap rate down.
What Factors Affect Cap Rates?
Countless factors will impact the cap rate of a property. The quality of the property, where it’s located and the current tenants will all have an impact on the metric. However, the most important factor is asset class.
“The cap rate is a function of the overall market (property segment such as industrial, office, etc.), current interest rates, quality and condition of the property, size of the investment, the existing lease terms, and the credit of the tenants,” Walt Batansky, Chief Financial Officer of Avocat Group, explained.
Interest rates will also have an indirect impact on this metric. “As [interest] rates rise we often see cap rates rise as well, although the change in cap rates will usually lag behind in their adjustment. If debt costs rise, cap rates have to rise as well,” said Dane Thomson, a Strategic Real Estate Advisor at Real Estate Bees.
What Is a Good Cap Rate?
There is no one-size-fits-all answer to what makes a good cap rate. An ideal cap rate will depend on the level of risk an investor wants to take. Riskier properties, like hotels and offices, will have some of the highest cap rates in the CRE world. Steadier performers, such as multifamily or triple-net leases with credit tenants, will have much lower cap rates.
According to CBRE, cap rates have been steadily declining in the past decade. In 2010, the average cap rate was 8.5%, and in 2021 the average cap rate was 5.4%. The industrial and multifamily suburban sectors have seen the steepest decline.
When to Use Cap Rates
You’ll likely see cap rates appear on most listings for CRE properties. A cap rate is an initial indicator of how profitable you can expect your investment to be. The cap rate also provides information on how much cash flow is available for debt service when financing an acquisition. If the cap rate is higher than similar properties, it may be a good deal, or there may be issues with the property such as deferred maintenance or leases that expire soon.
When Not to Use Cap Rate
Even though cap rates are frequently used, they do not tell the full story. Cap rates do not account for financing or taxation, nor do they typically account for tenant improvement costs or other capital expenditures. Cap rates also do not capture more nuanced but important details about a property, like the length of leases, the potential for new tenants and other factors that will play a large role in the future profitability of a CRE property.
For example, a cap rate can be misleading if the current rents are above the market rate. “Often we see leaseback investments where the rents are higher than the market. The cap rate might be good, but if at lease expiration the tenant leaves and you can’t get equal or great rental terms, then your net operating income will decrease and you will lose value,” Thomson explained.
To avoid a scenario like this, you have to take a birds-eye view of the rents for this property and other comparable properties. “You have to evaluate the market or submarket where the property is located. Are values and rents increasing or is it stagnant? Or is it a downward trend?” Thomson asked.
Of course, there are other items to consider in addition to the cap rate. “You also need to understand who the competition is in relation to the property you are evaluating — are your property’s rents in line with the market/submarket? Are the rents too high, making the property overvalued, or are they low, allowing you to push rents and increase income and value?” he explained.
Common Misconceptions About Cap Rate
Given how frequently the cap rate is used in the CRE industry, new investors can place too much emphasis on this metric at the expense of other factors that are also important to consider. “Some new CRE investors believe cap rate is the only thing you need to look at when evaluating a property,” Thomson told Leverage.com.
Batansky shared that another common misconception about cap rates is that there is some type of typical or standard cap rate to use to estimate a property value. “It’s complex and very hard to generalize,” he said.
Cap Rate Examples
Here are some examples of properties with a range of cap rates in different asset classes. Some databases, such as LoopNet, will allow you to search for properties based on the preferred minimum and maximum cap rates.
Multifamily property in Los Angeles: 6.14% Cap Rate
This five-unit class C apartment complex in Los Angeles has a cap rate of 6.14%. The apartment units are in good condition and have recently been renovated. The building is being sold for $1,350,000, totaling $270,000 per unit.
Based on the information from the post, you’ll be able to calculate that the NOI is $82,890 per year, which is the amount of income this property yields per year after expenses.
6.14% (Cap rate) = net operating income (NOI) / $1,350,000 (property’s sale price)
NNN Lease in Lakewood, Colorado: 4.50% Cap Rate
This Class B new construction in Lakewood, Colorado is a new construction that will come with a 15-year NNN lease for 7-Eleven’s Laredo Taco and eight gas pumps. The building has a cap rate of 4.50%. With a corporate-backed NNN lease, an investor is guaranteed income for the duration of the lease — which is 15 years in this case.
Hotel in Illinois: Value-Add opportunity with 10%+ Cap Rate
The owner of this family-run resort in Illinois is looking for a strategic partner to take this property to the next level. Properties with a cap rate of 10% or higher will typically require more risk, either in the form of a strategic or a value-add investment.
Cap Rates vs Interest Rates: What’s the Difference?
The interest rate is the cost a lender charges to borrow money. The interest rate can drastically change the cost of a deal and the potential profit. When interest rates are high, cash flow after debt service is lower for a given investment and therefore property prices usually go down, which would result in increased cap rates (usually with a delayed response).
Another metric, the cap rate spread, is the ratio between the cap rate and the interest rate. The higher the cap rate and the lower the interest rate is, the more profitable a property will be.
Cap Rate Is An Essential CRE Metric, But Doesn’t Tell The Full Story
Cap rate is an essential CRE metric, frequently used as the initial metric to evaluate the profitability of an investment. Using cap rates makes it easy to compare different properties of the same asset class in the same market, and will tell you the income you can expect relative to the purchase price of a property.
But cap rates are the beginning of a valuation exercise, not the end. It’s important to consider all of the factors that will lead to a profitable investment and an acceptable return on invested capital. There are many steps between NOI and after-tax cash flow to investors, and many factors that will change these metrics over time. Prudent investors will consider a variety of factors in order to deploy their capital wisely.