Commercial real estate investors use many metrics to measure the risk and benefits of buying a property. One of those measurements is the capitalization rate. In commercial real estate investing, the capitalization rate is a percentage that indicates the rate of return on a property.
Capitalization rates, also known as cap rates, vary depending on the local market and the property type. Using the capitalization rate formula helps investors compare properties and narrow down their investment options. How do you determine cap rates? And what do they tell you about a commercial property? Find out more in this brief article.
Hop to:
- Calculating Cap Rate
- What’s a Good Cap Rate?
- Factors that Affect Cap Rate
Determining the cap rate is straightforward. You need the property’s net operating income and current asset value. You’ll divide one by the other.
Capitalization Rate Formula:
Cap Rate = Net Operating Income / Property’s Current Value
The cap rate and the return on investment (ROI) are not the same things. Your ROI shows a projected return over a specific period. A cap rate indicates what the return on the investment is now. You can use the cap rate to determine how risky the investment is and how long it will take to recover your initial purchase.
1. Find the Net Operating Income
The first step in determining the cap rate is to estimate the property’s net operating income. Add annual rents and other sources of income together. Then, subtract the operating expenses. The number you end up with is the net operating income.
Net Operating Income = Gross Income – Operating Expenses
Your operating expenses are anything you will pay for to manage and maintain the property. Common operating expenses include:
- Utilities (that fall on you, not your tenants)
- Maintenance
- Property taxes
- Insurance
Let’s say a commercial property yields $100,000 in rental income per year. The property’s investor must pay $30,000 for maintenance and property taxes. Following the formula above, the property would have a net operating income of $70,000.
If you purchase a shopping center or several multifamily units, the property won’t always be at 100% occupancy. Most calculations leave room for potential rent loss to get a more realistic estimate of the net operating income. You can assume a vacancy rate of around 5% to 10% as a benchmark, which would make your occupancy rate anywhere from 90% to 95%.
Net Operating Income = (Gross Income x Occupancy Rate) – Operating Expenses
Using the same example from above, we’d see the net operating income change to $60,000 if we apply a 90% occupancy rate.
2. Divide by the Property’s Current Market Value
Once you have the net operating income, you divide it by the property’s current market value. While cap rates can be computed with the property’s original cost, calculating it this way may produce inaccurate results for older properties.
Our example property from step one has a market value of $1 million. Divide the net operating income by the property value. The result is the cap rate as a decimal.
$60,000 Net Operating Income / $1 Million Asset Value = 0.06
3. Convert Results to a Percentage
Convert the decimal to a percentage by moving the decimal point to the right two places. You can also multiply the decimal by 100 to convert it.
0.06 x 100 = 6% Cap Rate
Once you have the cap rate, you can use it to examine the investment’s risk. You shouldn’t use cap rates alone to make investment decisions. A property’s condition and location, along with many other factors, contribute to whether the property would be a good investment for you.
A “good” capitalization rate in commercial real estate is subjective and dependent on market context. Cap rates do not show you the total ROI. Instead, the cap rate shows the risk of investing in the property and how much time it will take to recover your initial investment. Whether or not you’re willing to take that risk is up to you.
Average cap rates range from 4% to 10%. Generally, the higher the cap rate, the higher the risk. A cap rate above 7% may be perceived as a riskier investment, whereas a cap rate below 5% may be seen as a safer bet. If a property has a 10% cap rate, you should expect to recover your investment in about 10 years.
When buying commercial real estate, higher cap rates indicate that the initial investment will be lower. If you’re selling a property, a lower cap rate works in your favor because it indicates a higher property value.
National Cap Rates
Cap rates fluctuate depending on the economy. Researchers at CBRE collected 3,600 cap rate estimates from 50 U.S. markets in 2021. Stimulus measures affected interest rates and caused a national decline in cap rates throughout 2020 and 2021.
As the commercial real estate industry bounced back from 2020, industrial properties saw the most cap rate compression due to e-commerce growth in 2021. Demand for multifamily assets increased as people moved away from big cities, which added to the declining cap rates.
In February of 2022, the National Association of Realtors reported that cap rates were trending downward compared to pre-pandemic levels. While cap rates fall, 10-year Treasury notes are trending upwards.
February 2022 Median Cap Rates
- Multifamily: 5.1%
- Office: 7.1%
- Industrial: 6.3%
- Retail: 6.9%
Analyzing risk isn’t only about computing the property’s cap rate. Investors should review contextual factors to determine if the commercial property is a sound choice. The property’s location, condition and type influence its value and associated risk. When you look at the whole picture, you’ll have a better idea of whether the commercial property will work for your purposes.
Location, Of Course!
Everyone knows that finding the perfect location is crucial for commercial real estate. The right location brings in more business, increasing profit for tenants and investors. A riskier location, such as one on the outskirts of town, will likely have a higher cap rate. An out-of-the-way location lowers the prospect of seeing a return on your investment.
The Type of Asset
Some types of property are generally riskier than others. Hotels are considered risky business investments because their profitability depends heavily on the economy. If the economy is good, people will travel, take vacations and stay at hotels. When the economy is bad, people will stay home, and hotels lose business.
Multifamily properties are thought to be lower-risk investments because they are often in demand. People will always need places to live, even if they aren’t spending money on other products and activities.
The Asset’s Class & Condition
Commercial real estate is categorized into classes. A Class A building is a top-tier space with premium rent rates and updated finishes. These properties are in new to like-new condition and located in desirable areas.
More often than not, a Class A building will have a lower cap rate because it has a higher value. A prime location and an attractive aesthetic add to the property’s total value and appeal.
Class B properties are those in between Class A and C properties. They are the middle ground between luxury and basic function. These properties may be slightly older, but they are still well-maintained. The cap rate for a Class B property falls below a Class A rate and above a Class C rate.
Lower-value Class C properties have higher cap rates. The risk that you won’t get a return on your investment is higher based on the location and condition of the property. Class C properties might be on the edge of town, or they may be older and not maintained. These properties are functional but not aesthetically impressive. You may take a more significant risk investing in this type of property; however, your initial purchase price will be less.
As an investor, you must weigh the risks and benefits of purchasing a property. Capitalization rates help commercial real estate investors predict associated risk. Higher cap rates generally indicate riskier investments that will take more time to see a return. Yet, properties with high cap rates also cost less to buy initially.
When you interpret the cap rate, consider your financial standing and long-term plans. An investment property may fit your needs, even if the cap rate isn’t what you’d like it to be. Cap rates are a tool to guide your investment decisions. You are the one who decides to make the investment.
Contact Commercial One Brokers today. We maintain a detailed database of all multi-tenant commercial properties of 5,000 sq. ft. and larger. Our data includes rents, occupancy rates, CAM charges and recent CAP rates for sold properties.
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