What is a Cap Rate in Commercial Real Estate?


Key Takeaways

Key Takeaways

  • There are a variety of metrics that can be used to assess the potential return on a commercial real estate investment.  One of the most common is the Capitalization Rate.
  • The Capitalization Rate, or Cap Rate for short, is defined as the annual return that can be expected on an all cash purchase of a property.
  • The Cap Rate is calculated as a property’s Net Operating Income divided by its purchase price and the result is expressed as a percentage.
  • While the formula for calculating the Cap Rate is relatively simple, the inputs can be affected by a number of factors that are more complex.  They include: the risk free rate, income growth rate, tenant lease duration, property type, and location.
  • There is no “good” cap rate because return expectations for each individual investor are unique and based on their risk tolerance, time horizon, and perception of risk associated with the property.

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There is a common saying in real estate investing circles that states “something is only worth what someone is willing to pay for it.”  One of the most common ways real estate investors determine what a property is worth is by using a multi-purpose metric known as the Capitalization Rate or “cap rate” for short.

What is the Cap Rate in Commercial Real Estate?

A commercial property’s Capitalization Rate is a measure of its potential return on investment assuming that it was purchased with cash.  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, the property’s Net Operating Income (“NOI) and Purchase Price / Appraised Value (or estimated current market value).  The Cap Rate calculation formula looks like this:

To illustrate how the Cap Rate is useful when comparing properties to each other, assume that an investor is trying to decide which of the following three properties to invest in:

Net Operating Income is defined as a property’s income less operating expenses.  Each of the above properties has a different amount of Net Operating Income/cash flow and a different purchase price, but their cost relative to the amount of Net Operating Income they produce can be assessed using the Cap Rate. The lower the Cap Rate, the more expensive the property is so, in the table above, Property #2 is the most expensive because it has the lowest Cap Rate.  Or, another way to look at it is that, in purchasing property #2, an investor would earn the lowest return relative to their investment.  To understand why this is the case, it is important to understand what factors go into an investor’s decision as to whether or not a Cap Rate is considered to be a “good deal.”

Factors That Impact a Commercial Property’s Cap Rate

Another way to look at the Cap Rate is as a tool for measuring the perceived risk associated with purchasing a property in the commercial real estate asset class.  If a particular property is considered riskier than another, an investor is going to demand a higher return as compensation, meaning that the price they are willing to pay is lower.  Conversely, if a property is considered to carry less risk, on a relative basis, an investor is willing to accept a lower return, which means they are willing to pay a higher price.  To that end, a rational investor will consider the following factors when determining whether or not a Cap Rate is fair:

  • 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 because there is no compensation for the additional risk associated with the property investment.  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 “rent bumps”, 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 lease renewal rate may be lower than the current one.  In either case, there is a risk 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 a tenant with a weak financial condition has an increased risk of defaulting 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.  

It is important to note that many of the above factors 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.  For example, two investors could look at the same property and walk away with completely different perceptions of the risk associated with acquiring it.  One may view it as higher risk and 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.  In both cases, the purchase price is adjusted accordingly.

What is a “Good” Cap Rate for a Commercial Real Estate Investment?

Because the Cap Rate is used as a tool for comparing property prices and risk levels, it can be tempting 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.

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