When it comes to commercial real estate investing, understanding your potential return on investment (ROI) is critical. However, you’ll soon discover that there are many different ROI metrics to work with, each with slightly different applications. You might wonder where to start!
A popular ROI metric, and as good a place to start as any, is ‘capitalization rate’, or ‘cap rate’.
In this guide, we’ll delve into how to calculate cap rate for your investment property, and explore how understanding it can help you make smarter investment decisions.
What is Cap Rate?
Cap Rate, also known as the yield, offers a quick snapshot of a property's potential profitability.
It’s a calculation of the anticipated rate of return on an investment property based on the income the property is projected to generate.
Simply put, it’s a measure of a property’s expected profit over the course of a year, measured as a percentage.
To determine the cap rate, divide the net operating income (NOI) of a property by either its current market value or purchase price.
CRE investors use cap rates to compare different real estate investment opportunities. A higher cap rate usually implies a higher risk but also a higher return. A lower cap rate indicates a lower risk but also a lower return.
Cap rate alongside other CRE return on investment metrics, can help investors make well-informed decisions and to find a balance between risk and return that aligns with their overall investment strategy.
Factors Influencing Cap Rate
There are many factors that can influence a property’s cap rate. Having a grasp of these factors can help investors assess the potential returns and risks associated with different properties.
It’s worth noting that they should never be looked at in isolation as cap rate is normally influenced by several factors at once.
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They include:
Market Conditions and Location
Cap rate is significantly influenced by the conditions of the CRE market in the specific location of a property.
The same property might have completely different cap rates in a different market in a different location due to fluctuations in supply and demand.
For example, CRE markets in high-demand urban areas may typically have lower cap rates because the property costs are high. There’s also a low risk of the property remaining vacant for any length of time.
Risk Profile of the Property
The perceived risk associated with the property can also affect the cap rate. Factors such as the creditworthiness of tenants, lease duration, and market volatility can impact the risk profile.
Properties with higher perceived risks often command higher cap rates to compensate for the potential risk.
Financing Conditions
Cap rate can be influenced by how a property is financed, or the surrounding conditions of borrowing. For example, if interest rates are high, the cost of borrowing to finance the property increases.
An investor in this environment would likely seek a property with a higher cap rate which means the property has higher income generating potential.
This will help to offset the higher cost of capital.
Property Type and Condition
The type and condition of the property can also impact the cap rate. For instance, different types of properties—such as office buildings, retail centers, or multifamily residences—may have different typical cap rates.
The property's age and condition can also affect the cap rate as older properties may require more maintenance.
For example, a savvy investor considering an older property would want to compensate for the additional costs and risks associated with investing in such a property (such as increased repair and maintenance and possibly higher operating costs).
The property might need to be priced below market value to make the investment attractive to the investor. By lowering the property price, the cap rate will increase.
How to Calculate Cap Rate
Understanding how to calculate the cap rate is an essential skill for any CRE investor. It's a simple formula that requires just two main components: NOI and current market value.
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How to Calculate Cap Rate Step-by-Step
1. Determine the Net Operating Income (NOI)
NOI is the income generated by the property over a year, after accounting for operating expenses such as property management, taxes, insurance, utilities, and maintenance. It does not include mortgage payments or depreciation.
2. Ascertain the Current Market Value
This is the most probable price at which the property would sell in the current market. It can be based on recent comparable sales in the area or a professional appraisal or a BOV.
3. Apply the Cap Rate Formula
Once you have both figures, you can calculate the cap rate using this formula:
Cap Rate = NOI / Current Market Value
4. Express the Result as a Percentage
Multiply your answer from the previous step by 100 to calculate the percentage. For instance, if the NOI is $50,000 and the current market value is $500,000, the cap rate would be:
Cap Rate = $50,000 / $500,000
= 0.10 x 100
= 10%
Example 1
A commercial property generates a monthly . The current market value of the property is $2,000,000. Using the cap rate formula, the cap rate would be:
Annual NOI = $15 000 x 12
Cap Rate = $180 000 / $2,000,000
= 0.9 x 100
= 9%
Example 2
A property has an annual NOI of $75,000, and the current market value of the property is $900,000. In this case, the cap rate would be:
Cap Rate = $75,000 / $900,000
= 0.0833 x 100
= 8.33%
Remember, the cap rate is only one of many metrics used in CRE investing.
It should be used in conjunction with other metrics and analysis to make informed decisions about property investments.
What is a Good Cap Rate?
What constitutes a ‘good’ cap rate largely depends on an investor's risk tolerance, the local market conditions, and the property type.
A high cap rate often indicates a higher potential return but typically comes with increased risk, often related to location or property condition.
Conversely, a low cap rate suggests lower risk, usually associated with properties in high-demand areas or those in good condition, but with lower potential returns.
Cap rate should always be considered alongside other factors such as cash flow stability, tenant creditworthiness, and the broader investment strategy.
A comprehensive analysis integrating these considerations with the cap rate can provide a more accurate perspective of potential risk and return, aligning better with your investment objectives and risk comfort level.
For an insightful look at the CRE cap rate trends for 2023, as forecast by CBRE, read their US Real Estate Market Outlook Report 2023.
Advantages and Disadvantages of Using Cap Rate
While cap rate is a valuable tool for CRE investors, it has both strengths and weaknesses.
Advantages of using Cap Rate
- Provides a quick comparison between different properties based on expected return on investment.
- Aids in easily evaluating and ranking potential properties.
- Especially useful when analyzing properties across different markets.
- Helps assess risk levels tied to an investment, with higher cap rates often indicating higher perceived risks.
Disadvantages of using Cap Rate
- Relying exclusively on the cap rate to make investment decisions can lead to a skewed perspective.
- It doesn’t consider factors such as property financing, potential future changes in income or property value.
- Cannot predict unexpected costs like major repairs.
- The cap rate is sensitive to fluctuating market conditions, which can make it less reliable as a standalone indicator for longer-term investments.
Other Important Metrics in CRE Investing
Every metric gives a unique perspective on an investment property, and investors should use cap rate in conjunction with other financial metrics and qualitative factors to get a comprehensive understanding of an investment's potential.
Examples of other important CRE metrics to consider include:
Net Operating Income (NOI)
The annual income generated by a property after deducting operating expenses.
Cash-on-Cash Return
The income earned relative to the cash invested in a property. It factors in cash invested and includes allowances for debt and/or mortgage costs.
Internal Rate of Return (IRR)
Offers a more in-depth view of the potential return on an investment by considering the timeframe of the investment. It also accounts for finer aspects of returns, such as interest earned on rental income over time.
Equity Multiple
A measure of the potential earnings from an investment, relative to the initial equity invested.
Nominal Return
The return generated by an investment before adjusting for negative factors such as inflation, taxes, or other expenses.
Gross Rent Multiplier (GRM)
A ratio of the property's price to its gross annual rental income. It's used to calculate the value of income-producing properties.
Final Thoughts on Using Cap Rate in CRE
Understanding how to calculate cap rate and apply it in the right circumstances is an essential skill every commercial real estate investor should harness.
After all, succeeding in commercial real estate investment is not just about acquiring properties—it's about acquiring knowledge and applying it effectively.
Bear in mind that an astute investment strategy involves the examination of multiple ROI metrics alongside context-specific factors such as location insights and market conditions.
Making use of a GIS analytics platform, like AlphaMap, designed specifically for CRE, can supercharge your investment acumen. These platforms amalgamate a wealth of tools, metrics, and comprehensive analysis – helping you navigate the intricate landscape of commercial real estate investment with ease and confidence.
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