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:
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.
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
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.
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.
In addition to interest rates, macroeconomic factors can impact cap rates as well. For example:
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.
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.
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.
While cap rates are a helpful investment metric, they also have several limitations, including: