What is a Capitalization Rate?

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The capitalization rate—commonly referred to as the “cap rate”—is a measurement that is used to demonstrate the expected rate of return for commercial real estate investment properties. The cap rate is an annual measurement that is used by investors to compare different commercial properties for valuation and risk-return analysis. Cap rates and risk are inversely related, meaning the higher the cap rate, the more perceived risk. As such, California Coastal markets typically have very low cap rates as they pose significantly less risk than other secondary and tertiary markets with higher cap rates. This analysis is beneficial when determining a potential return on investment, however, should not be used as the sole factor in predicting the strength of a real estate investment. Understanding the cap rate and how to calculate it are good starting points to analyzing ROI on different property types, tenants, and locations.  

Understanding the Cap Rate

The capitalization rate is a common measurement for commercial real estate investors to better predict profitability and overall return on investment. It is used as a representation for annual yield and can therefore, provide insight as to a property’s intrinsic ROI.

When is a Cap Rate Used?

A cap rate is used by investors who are interested in buying and selling investment real estate as well as to measure the valuation and potential ROI in relation to other investments. Cap rates are also a tool used to access the risk/reward profile of an investors tolerance and strategy.  

What’s a Good Cap Rate?

The measurement of a cap rate isn’t always a clear answer as to a good or bad investment. Each cap rate depends on the context of calculation, the commercial real estate property, and the current state of the market. With that said, a “good” cap rate tends to be around 5% to 8%. The higher the cap rate, the more risk. Higher cap rates are traditionally associated with secondary and more tertiary markets.

Lower cap rates imply lower risks, so investors looking for a safe investment should aim for rates around 3% to 4.5%. Lower cap rates are more closely associated with larger MSA’s and the coastal cities of California. If you’re unsure as to how much risk you’re comfortable with, working with a professional can help you understand the risks and rewards associated with both low and high cap rate transactions.  

Calculating the cap rate is important because it helps investors compare forecasted profits based on the projected yield of each commercial property. By understanding the level of risk associated with an investment, investors can make decisions that they’re comfortable with. 

How to Calculate Cap Rate

Investors can calculate the cap rate using a simple formula. Beforehand, you’ll need to calculate the property’s net operating income (NOI) to use in the cap rate formula. The cap rate formula is as follows:

The NOI is calculated by deducting total operating expenses from the total expected annual income of an investment property. The current property value is based on the state of market rates. For a better understanding, assume that an investor is trying to determine which property will result in a higher yield. Higher cap rates tend to result in higher returns if the market’s standard return rate remains stable. Determining which property to invest in depends on the amount of risk an investor wants to take when compared to potential returns. Due to varying market standards, commercial real estate property investments are never guaranteed and should be considered from all angles.

For example, consider a multifamily property with a current value of $3,000,000. The property grosses about $200,000 in rent every year and incurs $50,000 in total operating expenses. Your NOI would be $150,000 ($200,000 – $50,000). To determine the cap rate, you would use the formula above: $150,000 ÷ $3,000,000 = 0.050. Therefore, your cap rate is 5.00%.

Cap rates can change if the net operating income increases, such as in the case after a renovation that justifies an increase in rent, or a great operator can find more efficient ways to manage properties. This is a very common approach in real estate know as value-add. This could also increase the overall property value, which would lower the cap rate.

How Cap Rates Are Used

Cap rates are primarily used by investors to get a comprehensive overview of the risks associated with commercial properties.

  • Comparing Properties – properties in similar conditions, locations, and usage can be compared to understand the difference in investment risk. Different cap rates of similar properties could indicate problems or opportunities—depending on the investor’s plans.
  • Determining the Value of a Property – Investors can gain an understanding of the overall value of a given property by dividing the NOI by the cap rate of similar properties.
  • Analyzing Potential Returns – as mentioned, cap rates give investors an idea of what they can expect regarding the profitability of different commercial properties.
  • Market Analysis – in many markets, investors and appraisers use cap rates to determine the strength of the market in general. Strong markets have lower cap rates due to higher demand for properties.

Limitations on Capitalization Rates

While using the cap rate is a great way to better understand investment risk and market analysis, there are some limitations on accuracy. Commercial properties that are used for specific businesses or non-rental functions don’t always result in accurate cap rate calculations.

Similarly, if a commercial property of any sort doesn’t have enough operating history, it becomes increasingly difficult to calculate the NOI and total operating expenses. The same concept is applied to cap rates in smaller markets, as there are fewer commercial properties for investors to compare, which can result in misleading cap rates. While calculating the cap rate is a great way to get a better understanding of commercial real estate investments, it should not be the only factor used when considering property.

For a stronger understanding of potential commercial real estate investments, PACT Capital is here to help. Our team of real estate capital advisors has years of expertise and a unique perspective on the market, giving us the capacity to meet our clients’ needs and help them achieve their goals. PACT Capital is a reliable lender working directly with owners, operators and borrowers to purchase commercial real estate properties, refinance existing properties, redevelop, or start a new construction of commercial properties.

To learn more, email info@PACTCap.com, or call 213-799-PACT (7228) today.