What Is Capitalization Rate?
The capitalization rate (also known as cap rate) is used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor’s potential return on their investment in the real estate market.
While the cap rate can be useful for quickly comparing the relative value of similar real estate investments in the market, it should not be used as the sole indicator of an investment’s strength because it does not take into account leverage, the time value of money and future cash flows from property improvements, among other factors. There are no clear ranges for a good or bad cap rate, and they largely depend on the context of the property and the market.
- Capitalization rate is calculated by dividing a property’s net operating income by the current market value.
- This ratio, expressed as a percentage, is an estimation for an investor’s potential return on a real estate investment.
- Cap rate is most useful as a comparison of relative value of similar real estate investments.
Understanding Capitalization Rate
Cap rate is the most popular measure through which real estate investments are assessed for their profitability and return potential. The cap rate simply represents the yield of a property over a one year time horizon assuming the property is purchased on cash and not on loan. The capitalization rate indicates the property’s intrinsic, natural, and un-leveraged rate of return.
Capitalization Rate Formula
Several versions exist for the computation of the capitalization rate. In the most popular formula, the capitalization rate of a real estate investment is calculated by dividing the property’s net operating income (NOI) by the current market value. Mathematically,
Capitalization Rate = Net Operating Income / Current Market Value
The net operating income is the (expected) annual income generated by the property (like rentals) and is arrived at by deducting all the expenses incurred for managing the property. These expenses include the cost paid towards the regular upkeep of the facility as well as the property taxes.
The current market value of the asset is the present-day value of the property as per the prevailing market rates.
In another version, the figure is computed based on the original capital cost or the acquisition cost of a property.
Capitalization Rate = Net Operating Income / Purchase Price
However, the second version is not very popular for two reasons. First, it gives unrealistic results for old properties that were purchased several years/decades ago at low prices, and second, it cannot be applied to the inherited property as their purchase price is zero making the division impossible.
Additionally, since property prices fluctuate widely, the first version using the current market price is a more accurate representation as compared to the second one which uses the fixed value original purchase price.
Those interested in learning more about capitalization rates may want to consider enrolling in one of the best online real estate schools.
Examples of Capitalization Rate
Assume that an investor has $1 million and he is considering investing in one of the two available investment options – one, he can invest in government-issued treasury bonds that offer a nominal 3 percent annual interest and are considered the safest investments and two, he can purchase a commercial building that has multiple tenants who are expected to pay regular rent.
In the second case, assume that the total rent received per year is $90,000 and the investor needs to pay a total of $20,000 towards various maintenance costs and property taxes. It leaves the net income from the property investment at $70,000. Assume that during the first year, the property value remains steady at the original buy price of $1 million.
The capitalization rate will be computed as (Net Operating Income/Property Value) = $70,000/$1 million = 7%.
This return of 7 percent generated from the property investment fares better than the standard return of 3 percent available from the risk-free treasury bonds. The extra 4 percent represents the return for the risk taken by the investor by investing in the property market as against investing in the safest treasury bonds which come with zero risk.
Property investment is risky, and there can be several scenarios where the return, as represented by the capitalization rate measure, can vary widely.
For instance, a few of the tenants may move out and the rental income from the property may diminish to $40,000. Reducing the $20,000 towards various maintenance costs and property taxes, and assuming that property value stays at $1 million, the capitalization rate comes to ($20,000 / $1 million) = 2%. This value is less than the return available from risk-free bonds.
In another scenario, assume that the rental income stays at the original $90,000, but the maintenance cost and/or the property tax increases significantly, to say $50,000. The capitalization rate will then be ($40,000/$1 million) = 4%.
In another case, if the current market value of the property itself diminishes, to say $800,000, with the rental income and various costs remaining the same, the capitalization rate will increase to $70,000/$800,000 = 8.75%.
In essence, varying levels of income that gets generated from the property, expenses related to the property and the current market valuation of the property can significantly change the capitalization rate.
The surplus return, which is theoretically available to property investors over and above the treasury bond investments, can be attributed to the associated risks that lead to the above-mentioned scenarios. The risk factors include:
- Age, location, and status of the property
- Property type – multifamily, office, industrial, retail or recreational
- Tenants’ solvency and regular receipts of rentals
- Term and structure of tenant lease(s)
- The overall market rate of the property and the factors affecting its valuation
- Macroeconomic fundamentals of the region as well as factors impacting tenants’ businesses
Interpreting the Capitalization Rate
Since cap rates are based on the projected estimates of the future income, they are subject to high variance. It then becomes important to understand what constitutes a good cap rate for an investment property.
The rate also indicates the duration of time it will take to recover the invested amount in a property. For instance, a property having a cap rate of 10% will take around 10 years for recovering the investment.
Different cap rates among different properties, or different cap rates across different time horizons on the same property, represent different levels of risk. A look at the formula indicates that the cap rate value will be higher for properties that generate higher net operating income and have a lower valuation, and vice versa.
Say, there are two properties that are similar in all attributes except for being geographically apart. One is in a posh city center area while the other is on the outskirts of the city. All things being equal, the first property will generate a higher rental compared to the second one, but those will be partially offset by the higher cost of maintenance and higher taxes. The city center property will have a relatively lower cap rate compared to the second one owing to its significantly high market value.
It indicates that a lower value of cap rate corresponds to better valuation and a better prospect of returns with a lower level of risk. On the other hand, a higher value of cap rate implies relatively lower prospects of return on property investment, and hence a higher level of risk.
While the above hypothetical example makes it an easy choice for an investor to go with the property in the city center, real-world scenarios may not be that straightforward. The investor assessing a property on the basis of cap rate faces the challenging task to determine the suitable cap rate for a given level of the risk.
A Beginner’s Guide To Commercial Real Estate Cap Rates
Commercial real estate – even more so than many other types of business – is littered with industry jargon.
To help clarify some of the confusion around specific terms for my audience and clients, I even published a short glossary of industry definitions a few years ago.
Brokers and investors love to use these terms. Still, they often forget that non-industry folks aren’t familiar with their language, leading to all kinds of communication breakdowns in the investment process.
One of those points of confusion inevitably revolves around the concept of “cap rates,” or capitalization rates.
If you’re thinking about purchasing a commercial property, chances are you’ve seen buildings offered at an “8% Cap” or “10% Cap.” That sounds fancy, but what the hell is a “Cap,” or cap rate?
It happens to be a significant factor in the buying and selling of commercial real estate. Still, many first-time investors allow it to fly completely over their heads, affecting the outcome of their future cash flow and profit.
By the time you finish reading this article, you’ll have a firm grasp on the concept, which is critical if you’re investing in commercial real estate … you need to know cap rates!
So, What’s A Cap Rate?
A cap rate (Capitalization Rate) is the ratio of Net Operating Income (NOI) to the property asset value. It’s used to identify the return an investor can expect to receive from an investment property.
So, as a quick example, if a property were listed at $500,000.00 with an NOI of $75,000.00, the cap rate would be 15% (75,000.00/500,000.00 = .15).
Unlike residential real estate, which is based on the price per square foot of nearby comparable properties, the value of commercial real estate is determined by the amount of return an investor can expect to receive.
Cap rates are determined by the market and will fluctuate depending on interest rates, available product, and property class.
Though not the only factor when evaluating a commercial real estate asset for purchase or sale, it is one of the most popular measures used.
Let’s take a closer look at how cap rates work, why they’re used, and some of the benefits of selling your commercial real estate property based on cap rates …
Why Are Cap Rates Used In Commercial Real Estate?
Now that we know what a cap rate is, why use it?
Cap rates give investors a glance at the investment opportunity presented by a property.
If the investment is offered at a 10% cap, you can expect to yield a 10% return; an 8% cap would yield an 8% return (both assuming you paid cash without financing).
Investors choose to invest at different cap rates depending on their risk tolerance. Lower cap rates tend to denote a stabilized property in a proven market. In contrast, higher cap rates may mean the property has vacancy, maintenance, or desirability issues – but more upside potential.
And each investment group will have a different acquisition method.
Some investors may prefer all cash, some may prefer heavy debt, and others may only utilize light debt.
In each of these instances, the actual amount of cash flow to the investors will change while the property still throws off the same amount in annual revenue.
So why use cap rates as a measurement to analyze a commercial real estate purchase? It offers one of the quickest and easiest ways to determine the cash flow potential of a given property so that any investor can have an “apples to apples” comparison of different investment opportunities.
How Do Cap Rates Work In Commercial Real Estate?
This is very similar to the last question in this article, but I want to use it to drive home the point …
As we now know, commercial real estate investments are primarily valued based upon the amount of income they bring to the owner.
So, investors are essentially purchasing the stability of the asset’s cash flow. A cap rate would be the anticipated cash-on-cash return if the asset were purchased in all cash.
For example, if an office building is listed at $1,000,000 with a 10% cap rate, that means that the annual NOI is $100,000.
To find the value of a property, we divide the NOI of $100,000 by the 10% cap rate (100,000/.1), which brings you to $1,000,000.
Should you always use this formulation when buying commercial real estate? Well, not necessarily…
When looking at the cap rate of a property, you must understand that the cap rate reflects the current condition of the property – that does not mean that those conditions will hold under your ownership. Leases could expire, tenants may renegotiate lease terms, or you could renovate and reposition the property – all of these changes could have an affect on your cap rate.
Let’s go through a few variables to keep in mind when looking at cap rates in the context of purchasing a commercial property.
The Strength Of The Tenant
The net operating income of a property can quickly fluctuate with a change of tenants. For example, a preferred developer for a national tenant or a credit tenant such as Walgreens builds them a space during a moment of growth in a city. The developer sells the project to an investor at an 8% cap rate, triple net. So what’s the problem here?
A credit tenant stays in a space for around 15–20 years, so the rate they are paying will be continuous, unless specified in the lease, over the 15-20 years. An investor may look at this property and assume that the property is a great performing asset, but this may not be the case for the next investor. The tenant is the reason why the cap rate is 8%.
If an investor buys the space at the wrong time, they could be in trouble. If Walgreens vacates the space after their lease, the owner will have to find another tenant. This tenant may pay a lower rent if the market rate is lower than it was 15-20 years ago; at this point, we can throw the 8% cap rate triple net out of the window. Though that’s unlikely in a Walgreens location after 15-20 years, it’s certainly not unheard of for your more rural tenants, like Dollar General.
The Timing Of The Acquisition
The net operating income of a property is calculated by subtracting the operating expenses from the revenues that a property generates. This calculation is done yearly, which means that the cap rate can fluctuate with time if those operating expenses end up increasing (or, less likely, decreasing).
Many factors can cause a change in a property’s expenses and revenue, which is why timing is a significant factor when looking at cap rates – don’t expect the cap rate of a property to be continuous throughout your ownership!
Another factor to take into consideration is whether the space is fully leased. An investor could be under the impression that an investment is safe since it has a low cap rate (usually, the more you stand to gain, the more you stand to lose).
But if a space is not fully leased, then the NOI of the property would be significantly lower than it would be if the property was fully occupied; this would, of course, have an impact on the cap rate associated with the property.
The Location Of The Asset
A property’s location is one of the main driving forces behind its market value; thus, the location affects the denominator (market value) in our cap rate equation. If a property is located in an expensive neighborhood, you might see a lower cap rate.
Because the value of the property could increase at a higher rate than the rate at which your NOI increases, and the investment may be seen as more stable. The more stable an asset is, the lower your cap rate will be since the investment risk is lower.
OK, OK, if I’m not entirely bullish on using cap rates as a reliable measure for purchasing commercial properties, what about selling?
Well, that’s an entirely different story …
The Benefit Of Selling Your Commercial Real Estate Property Based On Cap Rates
A cap rate is a great tool, but as some investors do not consider the potential downsides of cap rates (as we covered above), many don’t know when to pay attention to cap rates.
A savvy commercial real estate investor should never disregard any measure when buying or selling commercial real estate. Still, the cap rate formulation begins to shine when selling fully stabilized properties.
Let’s briefly put that into action …
If we buy a 40,000 square foot property for $4,000,000 or $100 per square foot.
Say you own a fully stabilized 40,000 square foot property that you purchased for $4,000,000 (or $100 per square foot). You’ve been leasing this property for $10 triple net, which gives you an NOI of $400,000, making this a 10% cap rate property.
Now you can take the opportunity to sell or leverage this property based on its cap rate, NOT its price per square foot (or other measurements).
If you sell the property at a 7% cap rate, your profit margin is the 3% difference between the cap rate the property is sold at and the cap rate at which it operates.
So, in this example, you’re looking at 5,714,285.71 (7% cap value) minus 4,000,000 or a profit of over $1.7 million!
You could also choose to leverage the property by valuing the property at a 7% cap rate.
Are you getting this yet?
Many investors love buying fully stabilized properties for their cap rates. Still, the genuinely higher-margin opportunities come from buying on, say, a price per square foot basis and then selling or leveraging a property based on its cap rate.
So the real benefit of selling your property based on cap rates should be obvious by now … it’s all about the money. The money back in your pocket, to be specific.