Cap Rate in Commercial Real Estate
When you are planning to purchase commercial real estate as an investment, you would always analyze if the property you’re buying is a good deal or not. You weigh out all the factors and specifics if the property is really worth investing in. Being a diligent investor, you always consider the potential returns by using different metrics before making an investment decision. You wouldn’t risk losing your money onto a property that will not yield strong returns, right?
One of the important metrics in assessing a commercial real estate investment is the Capitalization Rate. This article will talk about cap rate, its importance in commercial real estate investing, and how to calculate the cap rate and determine if it is a good cap rate, or a bad one.
What is a Cap Rate?
In commercial real estate (CRE), Capitalization Rate, or commonly known as “cap rate”, refers to the return metric that is used to determine the potential return on investment or payback of capital. It is a rate used in CRE to estimate the rate of return on a property based on the net operating income (NOI) that the property generates—expressed as a percentage, usually somewhere between 3% and 20%.
A property’s cap rate is a factual snapshot of a commercial real estate asset’s return. It simply represents the yield of a property over a one-year period assuming the commercial property is purchased on cash and not on loan.
How to Calculate Cap Rate
For something fundamental as a cap rate, the good thing is—it is not complicated to compute. For you to be able to calculate the commercial property’s cap rate, you’ll need two (2) things:
- Net operating income (NOI) of the commercial property
- Purchase price of the commercial property
Using these two (2) elements, you can easily compute the commercial property’s cap rate by using this formula:
Capitalization Rate = (Net Operating Income (NOI) / Purchase Price) x 100
To calculate the cap rate, you take the net operating income (NOI) and divide it by the purchase price of the commercial property. Since cap rates are expressed as a percentage, you multiply it by 100.
To better understand the equation, it is helpful to break down the components and explain them individually. A property’s annual Net Operating Income (NOI) is the income minus expenses and the purchase price is the assessed sales price. If for instance, the purchase price is not available, the current market value or the appraised value can be used. Generally, cap rates have an inverse relationship to the property value. With that being said, the higher the cap rate, the lower the purchase price, and vice versa.
For further explanation of the terms like the net operating income (NOI), check out our article 25 Real Estate Terms You Should Know.
Importance of Cap Rate
The cap rate is commonly used by investors in deciding whether to pursue a commercial property or not. It is also used as a baseline in comparing investment properties in a given market.
When comparing commercial properties in the immediate market, you see a property that has a cap rate of 6.75%, another property at 7.35%, and a third property at 7.50%. While the property you are planning to purchase has a cap rate of 7.10%. This will tell you that the property you’re purchasing is in the middle and is fairly comparable to the expected returns and sales prices of other commercial properties that are listed in the market.
However, if you see that the other properties in the market have low cap rates around 4-5%, then it is a red flag. Why would the commercial property you’re eyeing sell for such a low price compared to the amount of income it can generate? Or is there something wrong with the commercial property you’re planning to purchase?
Another importance of cap rate in CRE is that it can be an indicator of potential risk. Commercial properties with higher cap rates tend to be in developing areas and thus come with more risk. While commercial properties with lower cap rates are found in areas that are more stable and with great demand. That’s why it comes with higher purchase prices.
In other words, using a commercial property’s cap rate may be helpful when looking to value a property at purchase and to compare that particular property to the sales of other similar properties in the market.
What is a “Good” Cap Rate?
A question that is asked by many people who are new to the real estate industry. The short answer is, it depends on how the cap rate is being used. Let’s say you are selling a property, having it be at a lower cap rate is good because the value of your property will be higher. On the other hand, if you are an investor planning to purchase a commercial real estate property, typically you would go for assets that have a higher cap rate so that your initial investment will be lower.
Although cap rate is an important metric being used in comparing investment opportunities, investors should not only base his or her decision in purchasing a property solely on cap rates alone. A good investor always considers all the elements that make up a property.
In addition, it is important to keep in mind that different cap rates represent different levels of risk. A low cap rate poses a lower risk, while a high cap rate poses a higher risk. With that being said, there is no “ideal” cap rate—it all depends on the investor’s risk tolerance.
Even after outlining all the information above, investing in CRE can still seem daunting. That’s why the Leveraged CRE Investment Team at Commercial Properties, Inc. is here to help you achieve your investment goals. Contact us at (480) 330-8897 or send us an email at email@example.com.
Need help on how to get started investing in commercial real estate? We got you covered! We prepared a free e-book that will serve as your guide to achieve your long-term business goals or obtain that property you’ve always been dreaming of!
Phill Tomlinson is a commercial real estate broker with Commercial Properties, Inc. (CPI) in Scottsdale, Arizona, and owner of the Leveraged CRE Investment Team specializing in investment sales and tenant/landlord representation in the Phoenix and Scottsdale submarkets. Phill applies over 21 years of experience in the Real Estate industry helping investors and owners maximize their returns.
Bookmark www.leveragedcre.com to learn more about the Commercial Real Estate market and keep informed of relevant real estate strategies designed to maximize your income property investment results. Connect and follow Phill on Social Media at sm.leveragedcre.com/smplatform. #LeveragedCRE