What are CAP rates (and why should I care)?

Commercial real estate owners and buyers are always confronted with the same question: “How do I determine the value of a commercial real estate property?”  Homeowners and homebuyers rely on the market data approach which simply looks at comparable sales in the market to determine value.  Commercial properties rely more heavily on the income approach or the income capitalization method to determining value.  The income approach requires an understanding of CAP rates or capitalization rates.

In order to begin the analysis, we need to determine the net operating income of the subject property.  The NOI is defined as the net cash flow of the property and is determined by taking the gross income and subtracting the operating expenses.  Gross income includes rents, common charges, parking income, and all other income sources.  Operating expenses are all of the costs associated with running the property, and include: vacancy allowance, management fees, real estate taxes, utilities, repairs and maintenance, etc.  The bottom line figure is the net operating income or net cash flow.  This NOI figure is what we will use to determine property value.

Investors have many options when it comes to investing their money.  They could deposit their funds in a bank account and these days earn 1-2% return on their money.  They could buy stocks and bonds with the hope of earning higher (but uncertain) returns.  Many choose to invest in real estate instead.  Let’s say an investor wants to earn a 5% return on his money and buys a property that generates annual NOI of $50,000.  That 5% return on investment is defined as the CAP rate.  In this case, the property would need to sell for $1,000,000 to yield $50,000/year at 5% return ($1,000,000 times 5% equals $50,000.  If the investor demanded a 6% return on his investment, the property would need to sell for $833,333 ($833,333 times 6% equals $50,000).  From this basic example you can see that a property value will change based on the rate that an investor will expect to earn on his investment.  In times when bank interest rates are high, real estate prices generally go down, as investors will expect to earn returns that exceed bank deposits.  When bank interest rates are low, real estate prices typically increase, as investors are willing to earn a lower return on their real estate investments.

Since September 2018, we have been seeing an increase in market interest rates.  If this continues and rates continue to rise, we could expect to see downward pressure on commercial real estate prices.

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