If you have found yourself in a conversation regarding commercial real estate investing, then the term cap rate or capitalization rate most likely came up. If you are looking to invest in commercial real estate, then you need to know and understand what cap rates are and how they are used. Capitalization rate or cap rate is a term used in commercial real estate to indicate the rate of return expected a commercial real estate investment property. It is a measure computed on the projected income which an investment is expected to generate. It is also used to estimate the potential return for an investor once they invest in a commercial real estate investment.
How Are Cap Rates Calculated?
The cap rate is the most popular measure of assessing real estate investments for their profitability and return potential. Cap rates in a commercial real estate investment are calculated by dividing the net operating income (NOI) of the property by the current market value.
The NOI is a calculation that analyzes the profitability of an income-generating real estate investment. It is calculated by taking all revenue from the property and then subtracting operating expenses. The operating expenses incurred come from managing and operating the property. These expenses could be items such as the cost of regular maintenance, salaries, and property taxes.
The Formula for Calculating a Cap Rate
Cap Rate = Net Operating Income (NOI) / Current Market Value
The current market value is the price an asset is likely to sell for in the current marketplace.
For example, if you were to buy an apartment property for $30,000,000 with an annual NOI of $1,650,000 then the cap rate is 5.5% ($1,650,000/$30,000,000).
Build-To Cap Rate
Build-to cap rates are primarily used by developers to determine the value created from building a new project. Build-to cap rates are computed on the basis of the original capital cost of a property. It is calculated as the net operating income divided by the purchase price.
Build-To Cap Rate = Net Operating Income (NOI) / Cost of Property
While analyzing the build-to cap rate can be useful in many scenarios, there are some situations when it is probably best to avoid using the build-to cap rate when analyzing a commercial real estate investment. For example, when purchasing an existing asset, the build-to cap rate may provide unhelpful results for old properties that were purchased several years when market prices were different than current market prices.
The first formula, NOI divided by current market value, is much more widely used because it provides room for the constant fluctuation of property values. and the commercial real estate market is always changing and there can be several scenarios and factors that affect cap rates.
Factors affecting the cap rate
Cap rates are affected by many factors. Performance of the investment, as represented by the NOI and the current market valuation of the property are the two largest factors. This makes sense since these are the two parts of the cap rate formula. Below is a list of factors involved in determining a properties cap rate.
· Age, location and status of the property
· Type of investment including multifamily, office, industrial, retail or recreational property
· The solvency of the tenants and regular receipts of rentals
· Term and structure of tenant leases
· Overall market rate of the property
· Factors affecting the valuation of a property
· Macroeconomic fundamentals in the region and factors impacting tenants’ businesses
How to Interpret the Capitalization Rate
Cap rates are based on the projected estimates of future income. As a result, they are subject to high variance. Therefore, it is important to understand what constitutes a good cap rate for a real estate investment.
The cap rate is also an indication of the duration of time it will take to recover the invested amount in a property. Take for instance a cap rate of 10%. This rate indicates that it will take 10 years to recover the investment.
There are different cap rates for different properties. There are also different cap rates across different time horizons on the same property. Lastly, different cap rates represent different levels of risk. When you take a look at the formula, it indicates that the cap rate value will be higher for properties that generate higher net operating income compared to their current market value or vice versa.
Cap Rate Comparison Example
Take an example where there are two apartment properties with similar attributes but are located in different geographical regions. One of these apartment properties is in a posh city center area while the other is on the outskirts of the city. With everything being equal, the property in the posh area will generate higher rental incomes compared to the second one but those will be partially offset by the higher cost of maintenance and higher property taxes. As a result, the apartment property at the city center area will have a lower cap rate compared to the second one since it is expected to have a significantly higher market value.
It is clear to see that a lower cap rate value corresponds to a higher valuation. Generally, a lower cap rate also means that the project is viewed as less risky. A higher cap rate implies the opposite, that is, relatively lower returns on investment and/or higher level of risk.
In this example, it is tempting for an investor to think that purchasing the apartment property in the city center makes the most sense. However, this is not a complete picture of the real world and the scenarios may not be that straightforward. When assessing a property on the basis of the cap rate, an investor faces the challenge of determining the suitable cap rate for a given level of the risk. If an investor has a low risk tolerance, then finding commercial real estate investments with lower cap rates make sense as this investor is willing to have a smaller return in exchange for more security. On the other hand, an investor who has a high-risk tolerance may want to consider commercial real estate investments with higher cap rates as these properties may have more potential for higher returns.
Using Cap Rates to Evaluate Commercial Real Estate Investments
A cap rate can be useful in comparing two different investment opportunities. For instance, a 5% cap rate acquisition vs. a 10% cap rate acquisition for a similar investment in a similar location should indicate to you that one of the properties has a higher risk premium than the other.
Cap rates can also be useful when they form a trend. Analyzing the cap rate trends in a particular sub-market will give you an indication of where the market is headed. If cap rates are compressing, then the values are being bid up and a market is heating up. Analyzing the historical cap rate data can give insight into the direction of valuations.
Given these important uses of cap rates, there are instances when they should not be used. For example, when a property’s net operating income stream is complex and irregular and has substantial variations in cash flow, the only way to yield a credible and reliable valuation would be through a discounted cash flow analysis.
There is a whole multi-layered process of evaluating commercial real estate. It begins with simpler tools like the cap rate before going to the more complex tools like the discounted cash flow analysis. The cap rate is a great tool that is widely used across the commercial real estate industry.
The cap rate is a useful measurement for comparisons of the relative market value of similar commercial real estate investments in the market. Nevertheless, it should not be used as the sole indicator of the strength of an investment because it does not take into account the time value of money and the future cash flows from property improvements among many other factors.
In summary, if you are looking into investing in commercial real estate, then the cap rate should be one of the indicators to be on the lookout for. It is a useful tool that is used alongside other ratios and measurements to assess commercial real estate investing opportunities.