Understanding Cap Rates in Commercial Real Estate

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The capitalization rate, or the cap rate, is a way to figure out the rate of return that you expect to generate on your real estate investment property. 

You can find out your capitalization rate by dividing the property’s net operating income (NOI) by the market value of the property. The cap rate is most beneficial when there are constant sales to compare and evaluate the costs to see if the offer price is reasonable.

It is essential to know that the cap rate does not provide a return on investment or ROI. Instead, the cap rate is simply an insight into how long it will take to earn back the money you initially invested into the property. The cap rate also does not provide a return rate for the investment’s life cycle. Instead, it just gives a snapshot of a specific period in time.

What is Cap Rate?

A real estate cap rate is based on the amount of risk and potential income one property has compared to others. Real estate investors determine the cap rate by applying a formula: 

  • Net Operating Income (NOI) / Property Price or Market Value = Cap Rate

Net operating income is the amount of money you expect to receive for the year after all rents have been collected and all operating expenses have been paid. NOI does not include debt service, depreciation expense, or owner’s expenses such as periodically traveling to the property.

If you inherit the property, there is no building cost, so you need to divide the current asset value by the NOI for the most up-to-date cap rate.

Factors That Can Impact Cap Rate

While the net operating income and the property’s current market value both influence the cap rate, several other factors affect the profitability of a commercial property.

Location

The location of your property will have an impact on current cap rates. For example, if your property is in a high-demand area with substantial in-migration and a growing economy, this will drive the prices up. Specific demographics will also have an effect, such as employment rates and median household income.

Suppose your property is in a competitive market. In that case, you will see lower, good cap rates than if your location was in a dwindling market: they’re lower for competitive markets because many investors perceive less risk.

Asset Types

The type of property you have also affects the current potential return. Retail properties usually have higher cap rates as they depend heavily on the economy for their business. Multifamily properties are traditionally safer investments as they rely more on people needing a place to live rather than on the economy.

Interest Rates

Interest rates can influence current cap rates as higher interest rates mean a longer time to pay the loans back. The longer it takes you to pay off the loans, the riskier it becomes. The federal government may also decide to raise interest rates by a certain percentage, which means that you must generate more revenue to bridge the gap.

Property Age and Class

The classification of a building can give insight into its age. Class A, B, and C classes are broken down into Class A, B, and C properties, and ROI can change depending on the property’s age and class.

  • Class A buildings are usually new or recently renovated and in high-traffic locations. Class A buildings are of the highest quality and should be in excellent condition. Expect the lowest returns from Class A properties.
  • Class B buildings are in less desirable locations where there may not be a lot of foot traffic. These buildings aren’t as new or in pristine condition, so the cap rates will be a little higher than a Class A building.
  • Class C Buildings are typically located in less-than-ideal neighborhoods, are older, and can be of poor quality. Due to the risk factors associated with Class C buildings, they usually have the highest cap rates.

Pros and Cons of Using Cap Rate

There are several benefits to using cap rates to help with your calculations when investing in a property. Cap rate calculators can be a great measuring tool, but it is best not to rely solely on cap rates when performing financial analysis. 

Pros

The pros of using cap rates are:

  • A convenient way to analyze an investment property quickly.
  • It helps you determine when to invest.
  • Easy to compare similar properties in the same market to help you choose the best one.

Cons

Along with the pros come the cons. Cap rates have a few:

  • Only provide a big-picture view of an investment decision rather than an in-depth look.
  • Cap rates rely on everything being stable for that year: the market, expenses, and vacancy rates. Since things change, this is not always a reliable measurement.
  • Cap rates are just a general calculation, but you should use other metrics for accuracy. These metrics include cash-on-cash, net present value, and internal rate of return.

The Bottom Line

While finding out the cap rate of a potential purchase, cap rate shouldn’t be the only form of measurement you use before you decide to invest in a property. It would be best to consider other factors, such as your cash flow. The deeper you analyze your investment property and the more information you have, the greater the chance of you making the right choice.

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