In order to thrive in the competitive world of commercial real estate, you’ll need a thorough understanding of capitalization rates, also known as cap rates. This important metric can help you evaluate the ROI of an investment property and can be vital in guiding your purchasing decisions.
This guide will introduce you to the basics of cap rates, showing you why they matter and how to use them to make better, more informed decisions. Whether you’re a seasoned real estate investor or new to the game, grasping the concept of cap rates will empower you to confidently navigate the market.
What Is the Capitalization Rate (Cap Rate)?
Cap rates — short for “capitalization rates” — are among the most fundamental concepts in commercial real estate. A cap rate represents the ratio between a property’s net operating income (NOI) and its current market value, expressed as a percentage. While cap rates are not the only metric that real estate investors should consider, the cap rate provides a helpful, objective snapshot of a property’s overall value.
What Do Cap Rates Do?
Real estate investors can use the cap rate to evaluate the potential return on investment (ROI) on an investment property. Cap rates will provide a clearer picture of the property’s expected yield over a one-year period so that you can make better-informed purchasing decisions.
As a general rule, a higher cap rate indicates a higher rate of return, though it can likewise represent a higher level of risk. Some industry experts recommend a cap rate of 8% to 12%, but there’s really no “ideal” cap rate. Investors will have to use these values to make balanced decisions about what property they may want to invest in.
What Are Cap Rates Best Used For?
While the cap rate of an individual property can be helpful, the best way to use cap rates is to compare similar properties. For example, if you are considering two or three investment properties of similar size or type, the cap rate can be used to compare the relative value of each property compared to the others.
For example, imagine that you are considering the purchase of two similarly sized rental properties. Which is the better investment? Cap rates can guide your decision by showing the relative ROI of each property and point you in the direction of the most profitable real estate property.
When Should You Use Cap Rates?
Cap rates can be used to influence your real estate investment decisions in multiple key areas. Investors should seek to use cap rates when:
- Evaluating the profit potential of a real estate investment
- Comparing the relative value of different real estate properties
- Assessing the risk of an investment property
- Making decisions about diversifying your real estate portfolio
Investors can use cap rates to compare investment opportunities and make decisions that balance profitability and investment risk. Again, cap rates should never be your sole decision-making factor.
However, they can “level the playing field,” so to speak, providing you with objective data that reflects the value of two different real estate properties. And because cap rates reflect risk as well as reward, investors can use this data to compile a well-balanced real estate portfolio.
How to Use Cap Rates
Now that you understand how cap rates work, you can start using them by applying the cap rate formula and putting your knowledge into action.
Understanding the Cap Rate Formula
Using cap rates is as simple as following a basic formula. The cap rate formula is simply the ratio between the property’s annual net operating income and the market value of the property itself.
So, a property presently valued at $400,000 with an NOI of $35,000 will have a cap rate of 8.75% ($35k/$400k). You can repeat this process for as many investment opportunities as you need to compare, giving you a fuller understanding of the relative value of multiple properties.
Step-by-Step Guide to Calculate Cap Rates
While the cap rate formula is simple, you may need to go through a few steps to hone in on the most valuable data. Here’s a step-by-step guide to calculating cap rates in real estate investing.
1. Calculate the Property’s Gross Rental Income
Start by determining the gross rental income for the property. This will be simple if the property is currently being rented since you can simply use the figures from the previous year. Otherwise, you can estimate the gross rental income based on properties of similar size and type in your area.
As an example, imagine that you have found a commercial property currently being rented for a total of $4,500 per month. Over the course of a year, this yields a gross rental income of $54,000 (12 x $4,500).
2. Calculate the Net Operating Income
To calculate your annual net operating income, you’ll need to subtract your operating expenses from the gross rental income.
- Management fees
- Property taxes
- Insurance
- Maintenance costs
To continue the above example, if the gross rental income of the property is $54,000, but taxes, fees, and insurance add up to $33,000, then the NOI becomes $21,000 ($54,000 – $33,000).
3. Determine the Property’s Purchase Price or Market Value
You now have the first half of the cap rate formula: the NOI of the property. Now, you’ll need to determine the property’s market value or purchase price. This depends on whether you currently own the property. If you own the property, you’ll use the current market value, which is the price you would pay if you were to buy the property today.
If the property is currently for sale, you’ll use the purchase price or the asking price for the property. Make sure to account for any closing costs, fees, or renovation costs you’ll have to spend to ensure the property is rent-ready.
4. Calculate the Cap Rate
You now have all the data you need to calculate the cap rate of your investment property. Continuing the earlier example, assume that the purchase price of the property is $350,000. Using the cap rate formula, simply plug in the numbers as follows:
Cap rate = $21,000 / $350,000
Cap rate = 6.0%
Again, this formula can be used for as many rental properties as an investor desires to compare, and the most meaningful information will likely be the relative cap rates of different investment properties.
Examples of Calculating Cap Rates
As you can see, cap rates are a straightforward calculation once you have the necessary information. But how do you use cap rates in residential vs. commercial real estate investments? To better understand this, it may help to look at some examples of using cap rates in real estate investments.
Scenario 1: Apartment Complex Investment
Imagine that you have come across an apartment complex that’s up for sale. How would you come to a decision about making an initial investment? Here’s how to use (and apply) the cap rate for a property of this type.
1. Determine the Gross Rental Income
First, determine the gross rental income of the apartment building. The complex consists of a total of six units, each with a rent of $1,800 per month. Ideally, this would come to an annual income of $129,600 ($1,800 x 6 units x 12 months), but the current apartment manager says that with vacancies and turnover, the annual average is closer to $115,000.
2. Calculate the Net Operating Income
Using the $115,000 estimate, you can calculate the net operating income by subtracting expenses like property taxes, management fees, maintenance costs, and more. Again, the property manager tells you that between the six units, the operating costs are roughly $55,000 annually. This yields an NOI of $60,000 ($115,000 – $55,000).
3. Determine the Purchase Price
Since the property is presently for sale, it’s easy to determine the purchase price. You can set the property’s value at whatever the current asking price is, though add on around 6% to cover closing costs and any unexpected repairs that may be required. For this example, assume that the cost of the six-unit apartment building is $1.1 million.
4. Calculate the Cap Rate
Now, you can apply the cap rate formula:
Cap rate = $60,000 / $1,100,000
Cap rate = 5.5%
If you want to determine the relative value of this particular apartment complex, you can run the numbers of other investment opportunities in your area to determine which one is the best investment.
5. Make a Decision
How might the cap rate influence your investment decision? For starters, a cap rate of 5% isn’t terribly high, though it may be more favorable than other apartments in your area. That said, it’s relatively low-risk, provided you have the capacity to keep the building filled with responsible tenants.
The final decision may be based on how the cap rate compares to others in your area and your desire to have an apartment building included in your real estate portfolio.
Scenario 2: Retail Property Acquisition
You can also use cap rates to evaluate the ROI of a commercial property. Here’s what the process might look like for investors looking into a retail property.
1. Determine the Gross Annual Income
First, determine the gross annual income. For commercial properties, this will depend on the contractual arrangement between you and the tenant. Will you charge tenants a flat rental rate or a percentage of their profits?
If the property is currently in operation, you can base the annual income based on current rental costs. Assume, for this example, that the retail space is currently generating $11,500 in rental income per month for an annual total of $138,000.
2. Calculate the NOI
To determine the NOI, you’ll subtract all the operating expenses from the gross annual income. For this example, assume that your monthly expenses come to $48,000, resulting in an NOI of $90,000.
3. Assess the Purchase Price
If the property is currently for sale, you can use the purchase price to complete your calculations. Again, for the present example, assume that the asking price is $1 million, though you anticipate that you’ll need another $125,000 to cover closing costs and a few improvements, leading to a price of $1.125 million.
4. Calculate the Cap Rate
You can now run the numbers to calculate the cap rate:
Cap rate = $90,000 / $1,125,000
Cap rate = 8%
As with residential properties, you can use the formula to compare cap rates for multiple commercial properties, though it may be most meaningful to compare rates between properties of similar size and industry.
5. Make a Decision
Keep in mind that commercial real estate can carry additional risk since the success of the tenants will influence the amount of rent that they can pay. Sales volume, inflation, and other cyclical trends may impact their ability to keep up with payments, which could impact your bottom line.
Still, a commercial property can be a great addition to a diversified portfolio, and comparing cap rates can help you make the best possible decision.
Cap Rate Tips and Special Considerations
Keep in mind that cap rates have limits. For one thing, cap rates are calculated based on the property’s current NOI without accounting for future earning potential. Cap rates also do not account for financing costs, market trends, or the time value of money. Additionally, cap rates themselves can be influenced by external factors.
Here are some tips for recognizing and responding to factors affecting cap rates.
Factors Affecting Cap Rates
Cap rates can be influenced by large economic factors as well as issues specific to each property. Here are some factors that affect cap rates:
- Interest rates can raise cap rates since borrowers expect a greater ROI
- A strong economy can increase real estate demand, increasing cap rates
- Inflation may increase rental prices, which can increase cap rates
- Property location can affect its desirability and the availability of tenants
- The quality of the property can increase desirability, boosting cap rates
Don’t forget that your tenants can also influence the ROI of your property. A long-term lease with creditworthy tenants will provide you with a steady income without significant risk, which gives you a greater chance of long-term gains.
Analyzing Market Trends
Real estate investment may sound like a full-time job in itself. How can busy investors stay on top of market trends? Here are some suggestions on how to learn about — and analyze — current real estate trends.
- Read industry publications
- Listen to real estate news and podcasts
- Network with local real estate professionals
- Attend real estate events and webinars
- Follow real estate thought leaders on social media
- Engage with clients to understand tenant behavior
When it’s time to make an actual decision, you’ll want to pay attention to historical data. Don’t just look at rental income from the most recent year, but look for changes and cycles that may impact future revenue.
The Long-Term Value of Cap Rates
Real estate investors should take special care to calculate and compare cap rates when making investment decisions. Cap rates provide an objective way to measure the potential ROI on a particular property, as well as compare the relative value of different investment options.
Now it’s your turn. Using what you learned in the above guide, you’ll be better equipped to navigate the world of real estate investing and make decisions that align with your goals. By understanding cap rates, you’ll invest more wisely and achieve investment wins that provide years of strong returns.
