A capitalization rate is one of the most common calculations used in evaluating investment real estate. It’s also one of the most misunderstood and misused metrics in commercial real estate.
Today we’ll clear up some cap rate confusion and discuss when – and when not – to rely on a cap rate to determine the value of a real estate investment.
What Is a Cap Rate?
A cap rate is a percentage figure that represents the annual cash a property generates for a commercial real estate investor. Cap rates are similar to bond yields. Right now, US Treasury Bonds return about 3% per year to an investor, while riskier and lower-rated BBB bonds yield about 4.5%.
Like bonds, cap rates go down as the perceived risk of the investment decreases. If a building presents more uncertainty to the investor, he or she will expect a higher cap rate in order to compensate for the greater risk.
How Is a Cap Rate Calculated?
A cap rate is calculated by taking a property’s net operating income (NOI) and dividing it by the market value, or asking price, of the property.
Cap rate calculations assume the property is being purchased with 100% cash. That means that the net income figure used is before interest and mortgage expenses and doesn’t include non-cash accounting expenses such as depreciation.
Net operating income / Market value = Cap Rate
$500,000 NOI / $10,000,000 Market Value = 5%
What Are Other Ways to Use the Cap Rate Formula?
The cap rate formula above can also be used by an investor to determine what a property’s income should be and what the market value should be. All that’s needed is two of the three parts of the equation.
How to use the cap rate formula to determine NOI
Let’s assume that a real estate investor is thinking about buying an office building with an asking price of $5 million in a market where the cap rates for similar office buildings are 3%. How much net income should the office building generate each year to justify the asking price?
If we plug the above numbers into the cap rate formula we find that the net operating income of the building should be:
$5,000,000 asking price x 3% cap rate (0.03) = $150,000 net operating income
If the property’s actual NOI is lower than that, the building might be overpriced, and if the NOI is higher the building could be a good deal.
How to use the cap rate formula to determine market malue
Now let’s say we have an office building listed for sale at $2 million in a market where cap rates for similar properties are 4.5%. The building generates an NOI of $50,000 per year. Is the property overpriced, underpriced, or priced just right?
For the building to be priced just right – or “at market” – it should have an annual NOI of $90,000:
$2,000,000 asking price x 4.5% market cap rate = $90,000 net operating income
But this building appears to be overpriced, assuming everything else is equal:
$50,000 NOI / $2,000,000 asking price = 2.5% cap rate
What should the asking price for the office building be using the market cap rate and the building’s NOI?
$50,000 NOI / 4.5% (.045) market cap rate for similar buildings = $1,111,111 market value
What Makes a Cap Rate Go Up or Down?
In this article we’ve used phrases such as might be, should be, could be, and assuming everything else is equal. But in commercial real estate, no two properties or deals are the same.
The above office building appears to be overpriced by about $900,000. But what if we told you that the city has just announced plans to build a mass transit center in the vacant lot next door, and that new office construction in the immediate trade area is virtually impossible? This would clearly increase future expectations for the profitability of the real estate asset at hand.
Factors such as future development, demand for space, and scarcity can all drive a cap rate down and the price of a property up. In a scenario like this one, investors are willing to pay more money for less net income because the property has very low risk.
On the flip side, a property that has a lot of deferred maintenance, an above-market vacancy rate, or brand new construction right next door will probably have an above-market cap rate. An investor will need to put more money into the building for repairs, offer more amenities to attract tenants, and lower the rents due to competition. All of these represent an additional amount of risk and uncertainty for the investor, meaning the cap rate should be above average.
Are Cap Rates the Same in Every Market?
Cap rates vary from market to market. They also vary based on the asset class and between smaller trade areas within the same larger market.
Generally speaking, primary markets such as New York and San Francisco will have lower market cap rates than secondary markets such as San Antonio or Phoenix. Secondary markets will have higher cap rates than tertiary markets like Wichita or Tucson.
Metrics that cause cap rates to vary from market to market include things such as gross domestic product, population growth, economic base, inflow of global capital, and possible major new employers in the area, such as Amazon’s second headquarters.