Capitalization rate, often shortened to cap rate, is a fundamental term used in commercial real estate (CRE). Gain insight into cap rate to maximize real estate acquisition knowledge and advance your investment property analysis.
What is cap rate?
Cap rate measures the annual rate of return on a commercial investment property. This percentage is discovered by dividing the net operating income (NOI) by the overall property price. NOI is the natural revenue generated by the property, or the rent paid by tenants, after subtracting operating expenses. The overall property value is the total price of the commercial property.
Cap Rate = Net Operating Income ÷ Overall Property Price
What factors into cap rate?
Several factors affect a cap rate equation. The NOI is affected by vacancies, the length of tenant leases, the types of tenant leases and the creditworthiness of the occupants. The value of the CRE is affected by the location, the current market, the quality of the structure or real estate and many other conditions. To fully understand cap rate, it is imperative for investors to evaluate these different factors.
Why does cap rate matter?
Cap rate is important to investors as it measures a commercial property’s return rate and enables simple comparison to comps. Additionally, the percentage of risk must be considered when determining cap rate. A property with low cap rate may have high vacancy and is, therefore, a high-risk investment. A cap rate can also be inversely affected by a property in poor condition, as the overall value may be lower. Because cap rates involve a multitude of contributing factors, the formula is best used to quickly compare properties of similar nature.
What is a good cap rate for CRE?
A “good” cap rate depends upon context and circumstance. As property price plays a major role in the equation, anything that dictates property value becomes of critical importance in determining good or bad cap rates. A cap rate may be regarded as high in Los Angeles and extremely low in Milwaukee. In high-demand locations, a cap rate of 5 percent can be considered a good investment opportunity. A knowledgeable brokerage services firm typically helps investors interpret and analyze cap rates.
When should investors NOT use cap rate?
Though cap rates provide valuable insight, it is important for investors to remember that they are largely based on income and are often projections of expected revenue. Unlike cash-on-cash returns, cap rates do not account for any debt on the property. Additionally, a commercial property with complex operating procedures and fluctuating expenses may not be represented properly by a one-year cap rate. These factors should be taken into consideration before investing.
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