More commonly known as the capitalization rate, the commercial real estate cap rate is a way for commercial real estate investors to assess risk and potential return of a commercial asset or commercial property. Commercial real estate cap rates, typically given as percentages from 2-30%, are a vital component of the investment process. Typically, an attractive cap rate for real estate is between 5-10%.
Understanding Commercial Real Estate Cap Rate and its Strengths & Weaknesses…
Commercial real estate investors, property agents and realtors use the cap rate to gauge the potential return on an asset or property to gauge the level of risk and the potential return. Investors determine the level of risk they want to take based on how long it will take to regain the original investment. Investment property with a low cap rate typically has a relatively higher value and lower risk. A high cap rate indicates the property is less expensive with a higher return (but greater risk).
While the cap rate helps investors assess property potential and is an important metric to consider for pipeline acquisitions, it is not the only metric since cap rates do not look at mortgages or financing. This is one of many limitations of commercial real estate cap rates. It assumes that the purchase will be made in cash. By considering only current rents, it does not look at factors that may affect future rents such as utilizing resources, money (if invested properly) is worth more over time, and renovations or improvements. Hence, cap rates may not always capture the complete market potential of a property. The internal rate of return is one of the metrics that investors look at in order to make their analyses thorough.
Cap rates are also not fixed, because they are affected by a variety of factors, including rent increases, additional tenants signing up, and changes in operating costs. There are several other commercial real estate metrics that investors use to evaluate the performance of their investments specific to the commercial real estate market. Similarly, private equity multiples are a measure of risk that is used in the market for private equity.
What Impacts Cap Rates in Commercial Real Estate?
- The Strength of the Tenant
- The Timing of the Acquisition
- Potential Vacancies
- The Location of the Asset
What is a Commercial Real Estate Good Cap Rate?
Rental properties
- The cap rate is a measure of the yield that can be expected from the rental property in the next year and is based on net operating income, excluding below-the-line expenses such as debt payments.
- A rental property purchased with a 5% cap rate that earns $100,000 per year in Net Operating Income, is worth $100,000 divided by 5%, or $2,000,000. The figure can also be viewed as a 20x multiple, where $100,000 multiplied by 20 equals $2,000,000.
- A cap rate calculation is useful because debt and interest are not included so it is possible to compare various types of rental properties based solely on initial investment, rather than the amount of debt to acquire. Particular financing options vary, but a cap rate can be used to forecast potential returns on a rental property based on its own attributes.
Investment property
- A reasonable caprate for an investment property is typically one that closely resembles market averages. If a noticeable discrepancy exists between the rates, this may mean that the property is undervalued.
- Cap rates can help investors to determine whether a property is a good fit for their investment portfolio and can be used to analyze existing properties.
- If the cap rate is much higher than other comparable properties, the property may be under valued, or the income could be too high. If cap rates are lower than what is average for the market, it would be a wise investment.
- A lower-than-usual cap rate could be a sign that a well-informed investor has the chance to improve on an underperforming investment. However, one cannot make this assumption only looking at cap rate. Investors must understand what is happening in the market in general as well as with a particular property.
Commercial property
- A good commercial real estate cap rate varies based on which side you are on. When it comes to the initial cap rate, the exit cap rate, and the holding cap rate, investors look for different things in each situation.
- As a real estate market expands, cap rates will begin to decrease, leading to cap rate compression since cap rates and property values are inversely related. Property prices may rise as demand for property rises too quickly, causing the market to heat up too quickly. As a result of a fall in borrowing costs, it is possible for buyers to demand more from sellers. It can be advantageous for a company to have a lower capitalization rate in this situation.
- In order for caprates to rise, the process by which they do so is known as cap rate expansion. There are many factors that can cause this to occur, such as an increase in the cost of borrowing, oversupply in the market, or worsening economic conditions.
- The cap rate can increase for different reasons, like when an anchor tenant leaves, or the building becomes damaged. This creates a perception that the property is riskier, which could be appealing to buyers who are willing to take on more risk if it means getting a discounted price.
Average Cap Rate By Property Class (Class A, Class B & Class C)
- It is common for cap rates to differ depending on whether you are purchasing a property in class A, B, or C.
- A property is classified into Class A, B, or C according to a number of different factors not easily defined. It is often thought that Class A office buildings are of the finest quality, are situated in the most convenient locations, and/or are in the most recent condition (newly constructed/renovated). There is a wide range of properties in the Class C classification, which tend to be older, located in less desirable areas, and in need of rehabilitation. Class B is basically the difference between a Class A property and a Class C property as it is intermediate between the two.
- There are a number of ways these scenarios fall apart, for example, if the property is in very good condition, but in an unattractive neighborhood, or if the property is in new condition, but not in the best condition. It is important to understand that, regardless of what the property’s “class” is, its cap rate will be affected by it. The cap rate of properties classified as class A is usually lower than the cap rate of properties classified as class B or class C.
Factors Affecting Cap Rate?
Expected Returns
Some investors prefer stability and steady income, even if earning less money overall. Some investors are willing to take on more risk if it means potentially receiving a larger reward. The expected/necessary rate of return is the percentage of return an investment must make for the investor to accept it given its unique attributes like cash flow volatility and availability of substitutes.
Income Growth
Even if the cap rate does not change, improvements in Net Operating Income can cause large changes in property value (and prospective returns). For example, for a 7% cap rate property - with the same cap rate, a$1 rise in NOI would mean a $14.28 increase in property value ($1 / 7%).
Return & Growth Expectations Due to Remaining Lease Duration
A rental property’s income stream is more predictable and less risky if there are many years left on its existing tenants’ leases. There is a significant risk of vacancy and income risk on a property if a tenant, especially a major tenant, has just one or two years left on their lease. In general, longer leases are associated with a lower cap rate and a lower level of risk.
Tenants Financial Strength
There is less risk in a property packed with top-notch renters who can be relied on to fulfill rent payments versus a property full of local tenants whose financial status is unknown. A target or subway, for example, will always attract a lower cap rate than a property with amenities such as a local coffee shop and restaurant.
How is the cap rate for a commercial property calculated?
The annual net operating income of a property is divided by its market value in order to calculate the cap rate. For example, a property worth $10million that generates $500,000 in NOI would have a cap rate of 5% if it generated $500,000 NOI each year.
Investing in commercial real estate is a great way to earn income and build wealth. Understanding cap rates is one key factor. The experienced team at Joseph & Camper Commercial can help and is ready with a wide range of services, including presenting you with properties for sale in the greater Peoria, Il area. Contact us today or call 309.691.5919.
