Exactly what is cap rate in commercial real estate? How is it calculated? What’s a “good” cap rate? What are the pros and cons of evaluating an opportunity using this metric? Let’s discuss answers to each of these questions.
Cap rate is short for “capitalization rate;” it measures the rate of return that an investment earns. You calculate the cap rate of a commercial real estate investment using the following cap rate formula:
CAP RATE = NOI / PROPERTY VALUE
where NOI is Net Operating Income and PROPERTY VALUE is the property’s current market value.
To calculate cap rate correctly you must know–or accurately estimate–the net operating income generated from the property as well as the parcel’s current market value. Dividing income by market value yields a cap rate as a percentage.
Calculating a cap rate can easily be calculated off an iphone calculator or the “back of a napkin”. Say, for example, you were considering the purchase of a property in downtown Chicago with a market value of $2,000,000. The gross income is $325,000, and the operating expenses $125,000 making your net operating income (NOI) $200,000 . Your cap rate for the property would be 10%, or yield you a return at 10% of your initial investment.
Is the 10% cap rate calculated above a “good” rate? The best answer is, “It depends.” Four big factors that affect a cap rate are 1) the location of the property, 2) the classification & age of the property, 3) creditworthiness of the tenant and 4) length of lease.
Commercial properties are placed in one of 3 tiers based on how fully developed the area is.
Cap rates are generally lower in Tier I locations than they are in Tier II and Tier III cities. That’s one reason that secondary and tertiary markets are becoming increasingly popular commercial investment locations.
Buildings are classed as A, B, C properties. The classifications are a bit fluid, but generally:
The creditworthiness of the Tenant is a major driving force as related to the value of your investment. For example, a long term lease to a company like CVS, Fresenius Kidney Care, or Chase Bank will have a much lower cap rate than a lease with a local or regional operating entity. Should you require bank debt to acquire an investment property, your Lender’s underwriting team will likely inspect the Tenant’s ratings, balance sheet, and the corporate guarantee that comes with the lease affecting the terms and conditions of your loan.
This is a simple concept, yet very important. The longer the term of the lease, the lower the cap rate. The risk associated as to what will happen after the tenant’s lease expires drives the value in lease. Be sure to understand that some lease agreements today have termination rights giving the Tenant the right to walk prior to the expiration date on the full term of the lease agreement. Your lender will likely underwrite the property to only the “firm term” of the lease.
Cap rates often range from 3% to 12%, with the lowest rates earned on Class A properties in Tier I locations. A cap rate of 4.00% might be a good rate if the property is in a posh location on a long term lease in the heart of Miami. In a market like Jackson, a 6.5% cap rate may be outstanding for a hard corner in a vibrant submarket with a national credit tenant. It’s important to understand the variables that drive the value so you can better evaluate the subject property no matter if you are on the buying or selling side.
Cap rate is frequently used by commercial real estate investors to compare between multiple purchase options. Although cap rate is an excellent tool, it needs to be used in tandem with other metrics as shown above. If you’re interested in learning more about how cap rates work and what drives the value behind this metric, be sure to reach out to one of our commercial real estate Mississippi specialists with your questions!