Cap Rates Explained for Beginners (with Cap Rate Calculator)
Commercial real estate – even more so than many other types of business – is littered with industry jargon.
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.
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!
Cap Rate Meaning
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!
Potential Vacancies
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.
Why?
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.
Frequently Asked Questions about Cap Rates:
What Is A Good Cap Rate?
A good cap rate typically depends on the local market and the investor's goals, but generally, a higher cap rate indicates a potentially better return.
What Is The Cap Rate in Commercial Real Estate?
A cap rate is the ratio of Net Operating Income (NOI) to the value of the property. It’s used to identify the return an investor can expect to receive from an investment property before debt service.
What Does 7.5% Cap Rate Mean?
A 7.5% cap rate means that the property's net operating income is 7.5% of its purchase price. For example, if a property is for sale at $100,000 and the cap rate is 7.5%, the net operating income of the property is $7,500 per year.
Is a 7.5% Cap Rate Good?
Whether a 7.5% cap rate is good depends on your investment goals, current interest rates, and risk tolerance. When interest rates are lower than cap rates, the property’s potential for cash flow is higher.
Is A 20% Cap Rate Good?
A 20% cap rate is relatively high and might suggest a favorable investment opportunity, but careful consideration of other factors is essential before determining its attractiveness. Remember that the higher the cap rate, the higher risk is associated with the investment.
Use Our Cap Rate Calculator:
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