In commercial real estate, there are few metrics as fundamentally important as the capitalization rate, or cap rate as it is typically referred to. However, how many commercial mortgage brokers and investors fully understand what a cap rate actually is?
Commercial property and owner-occupied homes are evaluated in very different ways. Those involved in residential real estate typically only evaluate the worth of a home by using comparable sales in its market. Since this method only takes market data and sales comps into account, and does not consider potential income, this method is insufficient for commercial or investment properties. Since the essence of investing in commercial properties is to generate income, the valuation of these properties relies on what’s known as the “income-capitalization method”. The income approach requires a deep understanding of cap rates.
Let’s consider an example to illustrate the essence of cap rates. Judy just came into some extra money and is considering where to invest it. She doesn’t want it to just sit in the bank and barely generate any passive income. She chooses to invest in an apartment building and determines that she needs to earn a 10 percent return on her money in order to mitigate against any potential risk. She proceeds to do some market research, falls in love with a property that generates annual net operating income (NOI) of $100,000 and purchases the property.
How does this example illustrate cap rates? Well, that 10 percent return required by Judy is defined as the cap rate. Essentially, in order for Judy to be willing to invest in a given property, she needs to be able to generate 10 percent of her initial investment in passive income each year. This directly impacts how much Judy should be willing to invest in any given property. Since the income of the property, or the NOI, is a fixed number at any one time, Judy should only purchase a property if its NOI will equal or exceed her required annual return. In this case, Judy should pay up to $1 million in order to purchase a property that generates $100,000 a year in NOI at a 10 percent return. Any purchase price above $1 million would not result in meeting her required cap rate. The reason for this is simple: $100,000 is 10 percent of the $1 million purchase price.
Let’s change the example up a bit. In this case Judy only demands a 5 percent annual return on her initial investment. Therefore, the same property would need to sell for no more than $2,000,000 in order for this property to interest Judy. So, the value of a commercial property will change based on the annual rate of return that an investor expects to earn. As the cap rate rises, the value of the commercial property must decline. Conversely, as the cap rate declines, asset prices tend to rise.
Calculating cap rates
But how do cap rates actually work? How does a commercial real estate investor use them to determine the value of a property? What is the basic starting point in this calculation? The first step in assessing the value of any commercial asset is to calculate its net operating income. NOI is the net cash flow generated by a property after subtracting the operating expenses from the gross income.
Gross income typically includes rents, parking revenue and all other sources of income. Operating expenses are the normal costs that inherently go along with running a commercial property. These costs typically include items like real estate taxes, management fees, repairs and maintenance, utilities, pest control and allowances for vacancies. Obviously different commercial properties will have different operating expenses and a precise calculation of income and operating expenses is required in order to assess the cap rate of any given property.
Once an investor determines the NOI of a property, he or she can take the next step at determining its value. In the case above, Judy did her due diligence and calculated that after subtracting the operating expenses from the gross income, the property generated $100,000 of NOI. This $100,000 needs to represent 10 percent of her initial purchase price (in the first example). Thus, she values the property at $1 million by dividing $100,000 by .1. Another way to express this same calculation is by multiplying $100,000 by 10 (10 percent of 100).
Another way to understand this concept is to state that a cap rate represents the annual return an investor expects to earn on an all-cash transaction without financing. If Judy were to invest $1 million into a property that generates $100,000 of net operating income, she would receive an annual return of 10 percent. At this point It should be abundantly clear now that the cap rate is inversely proportional to the sales price of a property. As mentioned before, if Judy were willing to buy the same property for $2,000,000 instead of $1 million, the cap rate on this investment would decrease in half to 5 percent.
What is good value?
Commercial real estate investors are constantly wondering what percentage represents a good cap rate. The answer to this question depends on many factors, including the geographic market, the risk inherent in the property and general interest rates in the market.
Let’s first consider geographic market. In flourishing urban and suburban markets, investors generally expect to see increasing prices and demand. In these markets, cap rates might be relatively low. On the other hand, in rural and diminishing markets, asset prices might be stagnant or decreasing, and tenant demand might be low. Lower typically translates to higher vacancy rates and longer lease-up times. In this type of market, an investor might expect to see higher cap rates.
The next thing to consider is the amount of risk within a specific property type. Apartment buildings are generally perceived as having the lowest risks and highest occupancy rates, while specialized single tenant properties might have the highest risks and longest lease-up periods. If one tenant moves out of an apartment building, the occupancy rate typically doesn’t crash and it’s often fairly easy to find a new interested tenant. However, if the tenant of a bowling alley were to vacate the premises, it might take many months, or even years, to find a new tenant. Often, extensive capital improvements are necessary in order to attract another tenant. These properties typically have the highest cap rates.
Lastly, we need to consider the fact that investing in real estate cannot be looked at in a vacuum. There are a whole host of places an investor can put his or her money and any real estate investor must evaluate a potential building against other possible investments. general interest rates in the market for other investments. The benchmark of investments is typically assumed to be the US Treasury. Treasuries are the safest investment you can purchase and have relatively zero risk as purchasing a Treasury bond is essentially betting on the US government. If an investor could buy a Treasury bond at a 2 percent return, the cap rate on any commercial real estate investment must include a premium over that 2 percent. Why would anyone buy a commercial property for a 2 percent return if they could buy an essentially risk-free Treasury bond at the same rate instead? While the amount of this risk premium depends on the factors that were discussed above, every cap rate must exceed the US treasury.
