Understanding the Capitalization Rate

Commercial real estate properties, even those within the same asset class, come in all shapes and sizes.  They have different locations, unit mixes, rental prices, finishes, conditions, and lease expirations all of which can make it difficult for real estate investors to create a true “apples to apples” comparison when evaluating investment options. 

To solve this issue, a metric called the  Capitalization Rate or “Cap Rate” for short is utilized and the inputs used to calculate it allow investors to compare properties, regardless of the physical differences.

What is the Cap Rate? 

A property’s Capitalization (“Cap”) Rate is a measure of its annual rate of return on investment assuming an all cash purchase.  For this reason, it can be a good metric to compare potential acquisitions, regardless of physical differences.  There are two major inputs needed to calculate the Cap Rate, Net Operating Income (NOI) and Purchase Price / Appraised Value (or estimated current market value).  The Cap Rate formula looks like this:  

Cap Rate = Net Operating Income

                     ¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯¯

                     Purchase Price

To illustrate how the Cap Rate works, assume that an investor was considering the purchase of the following two properties:

When comparing these two potential purchases, Property 2 is more expensive because the investor must pay more for a lower return on investment.  This doesn’t necessarily make it an inferior option, but is important for investors to understand why the Cap Rate is lower.

What Drives the Cap Rate?

Simply, the Cap Rate is a measure of the perceived risk associated with the stability of the income stream produced by the property.  The higher the Cap Rate, the higher the perceived risk and the lower the price.  Conversely, if the Cap Rate is lower, the property is perceived to have lower risk.  To this end, it is important to understand that the Cap Rate can be impacted by a number of factors:

• Expected Returns:  A property’s expected return is the potential return an investor requires based on the perceived risk associated with the asset.  The higher the perceived risk, the higher the expected return.  Properties with higher expected returns tend to sell for higher cap rates (lower prices) than those with less perceived risk.  
• Risk Free Rate:  Return expectations can be heavily influenced by changes in the interest rate on the 10-Year Treasury Bond, which is sometimes referred to as the “risk free rate.”  This is because a 10-Year bond is considered to be as risk free as an investment gets so all expected returns are measured relative to the interest rate paid by it.  For example, if the risk free rate was 5%, a logical investor would not buy a property at a 5% Cap Rate.  They would demand a higher return due to the higher risk associated with a real estate asset.  But, if the risk free rate was 1.5%, a 5% Cap Rate may seem acceptable because the “spread” is adequate compensation for the additional risk.  
• Income Growth Rate:  One of the major benefits of commercial real estate investment is that leases tend to have built in rental increases, which increases the amount of income the property produces over time.  Properties with high income growth rates tend to sell for lower cap rates (higher prices) than those with low income growth rates. 
• Lease Duration:  Rental properties with long term leases tend to command lower cap rates (higher prices) than those with short term leases.  This is because there is a risk with a short term lease that a tenant may decide not to renew and/or the renewal rental rate may be lower than the current one.  In either case, there is a chance that the income stream could be reduced.
• Tenant Credit:  Properties with tenants who are financially strong (CVS, Dollar General, Walgreens) tend to command lower cap rates (higher prices) than those with tenants whose financial condition is weak or unknown.  This is because there is an increased risk that a tenant could default on their lease payments, which would reduce the amount of the property’s income stream.
• Property Type:  Different property types tend to command different cap rates.  For example, Class A multifamily apartment buildings tend to command lower cap rates because they are generally considered less risky than an office building, which may command a higher cap rate.
• Location:  Properties with high traffic locations tend to command lower cap rates (higher prices) than those with low traffic locations.  This is because stronger locations tend to attract stronger tenants, which reduces tenant default risk and increases the stability of the property’s income stream.  For example, a well located investment property in New York or San Francisco would likely have a higher valuation (lower cap rate) than a similar property in Tulsa or Omaha.
• Replacement Cost:  A property’s replacement cost is the expense that would be incurred to rebuild the property from scratch and lease it to full occupancy.  Properties that are selling at or below replacement cost tend to command lower cap rates (higher prices) than those selling above replacement costs because there is less risk that a new investor would build a comparable property from scratch and lease it for similar rates.  

Despite the number of variables that impact the Cap Rate, it is important to note that many of these are “market driven” meaning that potential buyers will adjust their purchase price (the denominator in the Cap Rate equation) based on their own individual perception of the property.  So, it is not unreasonable for two investors to look at the same property and require completely different returns.  One may make an offer based on an 8% Cap Rate, while another may have a more optimistic view and be comfortable with a 7% Cap Rate.

So, What is a “Good” Cap Rate?

Given the prevalence of the cap rate in commercial real estate transactions, it can be tempting for an investor to ask, “what is a good cap rate?”  Unfortunately, there is no easy answer, it depends.

There is no cap rate that is better than another because they are all relative to the perceived risk associated with acquiring the asset, the risk tolerance of each investor, and the expected return.  For example, if one investor has a 10% annual return requirement, they would likely not be happy with an 8% cap rate.  But another investor with a 6% annual return requirement would likely be just fine with an 8% cap rate.

However, market cap rates for commercial real estate assets tend to range from ~4% for the highest quality, best located properties to 12% for properties that may have some physical, financial, location, or operational issues.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

When evaluating our own deals, we invest a significant amount of time and resources in analyzing a property’s cap rate relative to other options.  We view this as integral to our pre-purchase due diligence process and a factor in our success.  If you would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrealtypartners.com for more information.