Cap rates are a useful tool to evaluate commercial real estate investments. Learn more about a cap rate and how to calculate financial returns.

When evaluating a commercial real estate investment, it’s important to use certain financial metrics such as cap rates, or capitalization rates, to make an informed decision. 

In this detailed guide, you will learn everything you need to know
about cap rates, including:

• What is a capitalization rate?
• The cap rate formula
• What is a good cap rate?
• How interest rates affect cap rates
• How macroeconomic factors affect cap rates
• Cap rates: key limitations

What is a capitalization rate?

A capitalization rate, or cap rate, is an essential financial metric used to measure the expected rate of return on a commercial real estate property. Real estate investors consider the cap rate to be the most popular financial metric used to assess the potential profitability and return profile of an investment property. 

A cap rate represents the yield or rate of return of a property on an unlevered basis, meaning the property is purchased with cash and no debt. 

The cap rate formula

To calculate the capitalization rate of a real estate investment, the cap rate formula is:

Capitalization rate = Annual net operating income / Property’s current market value

So, to calculate the cap rate, you would divide the annual net operating income, or NOI, of a property by its current market value.
Net operating income is equal to the revenue of a property less its operating expenses. However, NOI is before interest, depreciation, amortization and taxes. The market value of the property is based on the current value of the property – not the original cost of the property – based on the value of comparable properties and recent sales of comparable properties. 

For example, assume that a commercial real estate property is currently valued at $10 million and produces $500,000 of annual net operating income. Assuming you acquire the property at its current market value, the cap rate for this property would be $500,000 divided by $10 million, which equals 5%.

As an investor, you can expect to generate a 5% return based on operating cash flow relative to the price you paid to acquire the
property.

What is a good cap rate?

If you’re wondering what is considered a good cap rate, there is no easy answer. Cap rates vary by property, sector and geography. Cap rates for a specific property also may be influenced by the condition or specific features of the property. 

A cap rate is a useful measure of risk. Generally, the higher the cap rate, the higher the risk and reward. For example, a lower cap rate can imply a better valuation with less risk. In contrast, a higher cap rate can imply a lower return profile and higher risk. Whenever you evaluate a property, always place the cap rate in context for the specific asset within a specific market.

How interest rates affect cap rates

The general rule is that higher interest rates mean higher cap rates. While there isn’t a strict correlation or causation relationship between cap rates and interest rates, a fast rise in interest rates could lead to an increase in cap rates. 

That said, multiple other factors can impact cap rates such as local economic conditions, supply and demand, and prospects for value appreciation and rent growth.

How macroeconomic factors affect cap rates

In addition to interest rates, macroeconomic factors can impact cap rates as well. For example:

GDP and Unemployment

The relationship between Gross Domestic Product (GDP) Gross Domestic Product (GDP) and unemployment indicates the general health of the economy. 

When unemployment is low and GDP is high, then cap rates tend to be lower.

Conversely, when unemployment is high and GDP is low, commercial real estate properties may present higher risk. 

Rent Growth

When inflation is high, rent growth can increase, which is a benefit to commercial real estate investors. In some cases, higher rent growth acceleration can increase Net Operating Income (NOI) and offset the impact of higher interest rates and inflation. Conversely, when the economy slows, rent growth can slow and cap rates can increase. 

Demand

High demand for a commercial real estate property can lead to lower cap rates. For example, a commercial property situated in the city center close to employment hubs, public transportation, and cultural and entertainment attractions can increase demand. In contrast, properties located farther from the city center without accessible public transportation or employment centers generally have higher cap rates. Why? These properties tend to have unstable demand, which can mean fluctuating occupancy, higher turnover and lower NOI.

Cap rates: key limitations

While cap rates are a helpful investment metric, they also have several limitations, including:

1. Assumes stability. Cap rates assume that the underlying asset’s income will remain stable. However, a property’s stability can change due to market dynamics, for example, which can impact cash flow.
2. Different NOI calculations. Cap rates typically are calculated with 12 months of net operating income. Investors can calculate net operating income in different ways, each of which can impact the cap rate. For example, an investor can use the last 12 months of NOI to calculate a cap rate. Alternatively, an investor could use the last month of NOI and annualize it by multiplying by 12 to calculate run-rate NOI. A property may generate higher or lower net operating income depending on the period selected.
3. Limited insights on financial performance. Since cap rates are based on NOI, a cap rate does not indicate whether the property’s financial performance is improving or declining. Rather, a cap rate shows the expected yield based solely on the stated net operating income.
4. Exclusion of mortgage. Since cap rates are based on NOI (which is before interest expense), cap rates do not include debt financing. Since most commercial real estate properties are financed with significant leverage, a cap rate can be less useful for buyers who use debt to finance a property’s acquisition.
5. Misleading risk profile. A high or low cap rate may provide misleading insights regarding an individual commercial real estate property’s risk profile. For example, a low cap rate in a major metropolitan area could mean an asset is stabilized with a secure, long-term tenant. Alternatively, a low cap rate in a different market could indicate a lower quality asset with high vacancy. Therefore, it’s critical to evaluate the specific property and market relative to the stated cap rate to understand the risk profile in context.