How to Use Cap Rate
March 26, 2019
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To adequately analyze a commercial retail investment opportunity, investors often refer to the capitalization rate (cap rate) for efficient comparison. Utilizing the cap rate can be an effective method to evaluate commercial real estate as it measures the potential annual rate of return on a property.

What affects cap rate?

The cap rate is attained by dividing a commercial property’s net operating income (NOI) by the overall property price. The elements that factor into these two components can significantly affect the resulting percentage. On a macroeconomic level, supply and demand of real estate drastically affect property value and, thus, cap rate. On a microeconomic level, how business tenants operate, market themselves and make decisions can have a considerable influence on their ability to stay in business and remain reliable tenants, which affects NOI and cap rate. Other important factors that affect the cap rate of commercial retail property are the location, types of tenant leases, property type, interest rates and the overall national economic prosperity.

Measure of Risk

Both sellers and investors interpret cap rate as a percentage of risk. A low cap rate often signifies higher property value. From an investors standpoint, the potential returns on a property with a low cap rate are lower but, therefore, less risky. Commercial retail property with a high cap rate is indicative of a lower purchase price, but also a high NOI. A higher NOI increases the risk for investors as it depends heavily on the reliability of the tenants and the well-being of the economy. Additionally, sale prices can be manipulated to show more appealing cap rates.

How to Apply Cap Rate

Though landlords typically prefer lower cap rates for higher selling prices, investors prefer higher cap rates because they have a lower purchase price and higher possible returns. The way cap rate is applied and interpreted depends on the personal preference of the investor. Additionally, it’s imperative to remember that understanding the degree of risk in a commercial retail property investment is substantially more complex than merely identifying the cap rate. Several external factors can display a low cap rate one moment and a high cap rate the next.  

Due to these considerations, cap rates are best used to compare and contrast similar markets or properties. A cap rate can also serve as a practical leveraging tool in the decision to sell a commercial property. The valuable insight that cap rates provide can assist investors and landlords in their endeavors, but effective application of this information requires the help of a knowledgeable commercial retail investment brokerage.

Interested in commercial real estate investment? Ground + Space is a leading commercial real estate brokerage firm that specializes in single-tenant and retail NNN investments. Contact us today to find out more about our current listings!


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