As professional commercial real estate investors, we may analyze and compare the potential cash flow of dozens of commercial properties before deciding to acquire one. But, this is easier said than done. All properties are slightly different, meaning they have different sizes, locations, tenants, and conditions so it can be difficult to perform a true “apples to apples” comparison. However, one of the ways that we can compare investment options is through the use of a metric known as the “Cap Rate.”
What is a Capitalization Rate?
A property’s Capitalization Rate or “Cap Rate” is a measure of its annual rate of return assuming an all cash purchase. As such, it can be a good metric to compare potential investment properties. The Cap Rate formula is:
In the formula, Net Operating Income is calculated as the property’s annual gross income, less its operating expenses and the purchase price is the amount specified in the sales contract. If this value isn’t available, it could be substituted with an estimate of the property’s current market value or the valuation specified in an appraisal.
The result of the Cap Rate calculation tells the investor a lot about the property’s risk and potential return. The higher the cap rate, the higher potential return. The lower the cap rate, the lower the potential return because the property is perceived to have lower risk.
For example, 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. This doesn’t necessarily make it an inferior option, but is important to investors to understand why the Cap Rate is lower.
What Drives Cap Rates?
A property’s Cap Rate is driven by a number of different factors, all related to the perceived risk of the stability of the income stream produced:
- 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 risk that a tenant may decide not to renew their lease 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.
- 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 property in New York or San Francisco would likely have a higher sale price (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.
- 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.
- Expected Returns: A property’s expected return is the return an investor would expect should they purchase it. If the property is perceived to have higher risk, an investor will demand a higher return. If the property is perceived to have lower risk, the investor may require a lower return on investment. Properties with higher expected returns, meaning higher perceived risk, tend to sell for higher cap rates (lower prices) than those with less perceived risk.
In addition, return expectations can change relative to investment alternatives. For example, the interest rate offered by the 10-Year Treasury Bond is commonly referred to as the “risk free rate”, meaning that this is as close as an investor can get to earning a risk free return on their investment. So, cap rates can change relative to the risk free rate. If an investor can earn 5% on a 10-Year Treasury Bond, they would certainly demand to earn a higher rate for the additional risk associated with a commercial real estate asset.
So, What is a Good Cap Rate?
The short answer is, 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. For example, the quality of the cap rate is influenced by: an individual’s investment strategy, the risk tolerance of each investor, the asset class (office, multifamily, industrial, retail) 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 average 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 firstname.lastname@example.org for more information.
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