One way to evaluate a pipeline acquisition property’s income-generating potential is by calculating its commercial real estate cap rate.
The commercial real estate cap rate of a property offers a glimpse into both the risk and return, helping investors to predict how it will fare compared to other similar market properties. In other words, the cap rate illustrates the potential ROI.
You can calculate the cap rate by taking the property’s net operating income (NOI), which is the gross income minus the expenses, and dividing it by the asset’s value.
In this blog post, we’ll explain what commercial real estate cap rate means, how to calculate them, how to use them in your pipeline evaluations, and more.
Definition: What Does Cap Rate Mean in Commercial Real Estate?
The commercial real estate cap rate, or the capitalization rate, is the return rate figure that CRE investors use to gauge the risk and potential return of an asset or property. Cap rates are expressed as percentages, usually from 3-20%.
When a cap rate is low, the property generally has a relatively higher value and lower risk. High cap rates, conversely, indicate that the property has a lower price, but also a higher return (and risk). Cap rates help investors understand how long it will take to recover the initial investment as well.
While cap rates help investors understand the property’s potential, they won’t necessarily provide tremendous value in a vacuum. Instead, cap rates are best used as a comparison tool against other properties in the same or similar markets. Even if you don’t move forward on a pipeline property, retaining that cap rate aids in future benchmarking and analysis.
While the cap rate is an invaluable metric to consider for pipeline acquisitions, it’s far from an end-all metric. Among other limitations, the commercial real estate cap rate doesn’t take a mortgage or financing arrangement into consideration, assuming a cash purchase instead. This figure is based exclusively on current rents, without considering leverage, the time value of money, and improvements or renovations. Overall, cap rates don’t necessarily capture the property’s full market potential.
Cap rates are not fixed, as the net operating income can change as rents increase, additional tenants sign, or as operating costs increase or decrease. This term is specific to commercial real estate, though investors in other markets use similar metrics to weigh investments. Overall, the concept is similar to multiples in equity markets.
How to Calculate Cap Rate for Commercial Real Estate (Formula)
How do you calculate the commercial real estate cap rate for a property?
The most common way to calculate a commercial real estate cap rate is:
NOI/current property value= capitalization rate
To convert this figure to a cap rate, simply multiply by 100.
You can calculate the net operating income by deducting management-related expenses from the annual income generated by the property. These expenses can include both standard upkeep and taxes. The current market value is simply the property’s value given the current market conditions.
For example, if the property generates $500,000 in income after expenses, and the current value is $5,000,000, then the cap rate is 10%. In other words, the investor is earning 10% of their investment on an annual basis. Because the cap rate is 10%, it will take the investor ten years to recover their initial investment.
While you can also find the cap rate by dividing NOI by the purchase price, this method is less popular and not as trusted. Purchase prices can often be out-of-date metrics, especially if the property has undergone significant renovations since the last purchase. It also eliminates considerations about market conditions.
Fortunately, calculating cap rates doesn’t need to involve tedious number crunching. Investors and analysts often determine cap rates using Excel spreadsheet formulas that pull in the NOI and property value. Unfortunately, simply logging figures in Excel can make for complicated historical data comparison. To make the most of their data, many investment firms utilize deal management software that simplifies this process by dynamically calculating cap rates, and allowing for comparisons based on filters.
What Is a Good Capitalization Rate for Commercial Real Estate?
Naturally, the goal of calculating cap rates is to determine whether or not a property is a worthwhile investment. This begs an inevitable question: what’s a good cap rate?
Unfortunately, there’s no easy answer. Cap rates are best used for market comparisons, rather than standalone evaluations. There are many moving factors that can influence whether or not an investor considers a cap rate “good”.
Rather than examining cap rates in a vacuum, your goal should be to compare pipeline property cap rates against historical comp cap rates to understand if the sale price aligns with your investment strategy.
For example, an investor may consider a cap rate of 5% in San Diego ideal, considering the risk profile and other factors. When considering a property in Atlanta, that same investor might also call a 7% cap rate ideal.
Average Cap Rate By Property Class (Class A, Class B & Class C)
While there may not be a magic number you should strive for across the board, there are benchmarks depending on the property type, class, and location, among other factors.
There are three basic property classes: A, B, and C. While the distinction between them is open to interpretation, the bottom line is simple. Class A properties are the most expensive and carry the lowest risk. Class C properties, on the other hand, are the least expensive with the highest risk. Finally, class B properties sit in the middle. These distinctions are subject to interpretation, but help create a baseline for evaluation.
According to First National Realty Partners, average cap rates by property class are:
- Class A: 4-8%
- Class B: 6-9%
- Class C: 7-10%
As previously mentioned, though, these figures can vary significantly by the location and the asset class. For example, multifamily properties may have lower cap rates than office buildings on average, as they are generally lower-risk investments.
What Factors Affect the Cap Rate?
Overall, the commercial real estate cap rate is a representation of the property’s potential risk and return. Some of the factors that influence the cap rate are:
- The length and rate of existing leases: Unlike properties with short-term leases, properties with long-term leases are guaranteed to generate consistent income for a longer period of time. Properties with shorter leases may lose income streams sooner, which results in higher risk. On the opposite side of the coin, leases below market rent value that are set to expire soon may be increased to meet current market standards, raising NOI.
- Credit scores: Tenants with lower credit scores are typically at a higher risk of defaulting on their lease, limiting investor earnings. For this reason, tenants with higher credit scores, who are less likely to default, generally help lower cap rates.
- Location: Properties that are located in larger urban centers, like New York and San Francisco, generally have higher prices than properties in smaller cities like Minneapolis. Given the higher selling prices, cap rates in larger cities tend to be lower.
- Replacement cost: When a building is valued at or below the cost of developing a comparable property, it generally earns a lower cap rate. Conversely, properties valued above the replacement cost have a higher cap rate, as investors could instead choose to simply develop a similar building.
- Property type: Various property types have different levels of risk associated with them. Multifamily properties, which have easier vacancies to fill than office buildings, make for lower cap rates.
- Property class: As outlined above, property classes are broken down based on the building’s state and implied risk. Class A buildings, which are more valuable and carry lower risk, have lower cap rates than class C buildings, which are less valuable and carry higher risk.
Understanding The Purpose of Cap Rates: What Do They Tell You?
Cap rates provide investors with insight into the risk they take on in purchasing it, as well as the return it could generate. Most importantly, cap rates act as a crucial benchmark for investors to compare against other assets on the market and to identify trends. Cap rates not only help investors calculate how much they stand to gain, but also how long it will take to reach that point.
Comparing Purchase Prices on Pipeline Acquisitions
The most strategic investment decisions are guided by data. Commercial real estate cap rates provide tremendous insight into risk and return, as well as market trends. Looking at cap rates prior to an investment helps investors understand how a property stacks up against historical comps, too.
Low cap rates indicate that properties will generate healthy income streams relative to their market value. High cap rates, on the other hand, indicate a higher-risk acquisition, without as much income compared to cost. However, one isn’t necessarily better than the other–investors with different strategies utilize unique criteria.
Considering Refinancing Options on Existing Assets
Because cap rates provide an (albeit limited) indication of a property’s value, they can be useful in considering refinancing. When investors are looking to save money by restructuring mortgage agreements, cap rates can indicate the property’s value through the loan-to-value evaluation. This helps investors understand if refinancing is possible, and to what extent it can help offset repayment costs.
Terminal (Exit) Cap Rates
Beyond immediate operating income from rents, investors also consider the long-term return of a property. Financial models can help investors predict a property’s value at the time of sale, or disposition, after development and at the end of the holding period.
While terminal cap rates accomplish the same basic function as standard cap rates, the formula is different. Instead of using the current market value, you can divide NOI by the expected sale price to calculate the exit cap rate.
For a deeper, more thorough analysis of these figures, some investors create models that take into account other factors, including:
- Purchase price
- Projected income and expenses (taking growth into consideration)
- Closing costs
- Senior debt
- Exit price
- Overall projected profit
Expediting & Simplifying Commercial Real Estate Cap Rate Analysis
While not the only important factor, commercial real estate cap rates are a crucial consideration investors should take into account. However, logging cap rates in Excel can be a time-consuming process that ultimately ends in a bottleneck- and error-prone comparison process.
As the leading deal management platform for commercial real estate investors, Dealpath simplifies the cap rate comparison process. By calculating cap rates via automated data sourcing utilizing configurable fields, Dealpath helps your team evaluate the metrics that are most important to you quickly and easily. While evaluating incoming pipeline acquisitions, Dealpath’s filtering tool allows you to quickly compare pipeline opportunities against historical data, ensuring you can make your data your competitive advantage.
To learn more about how Dealpath makes your data your competitive advantage by simplifying the cap rate comparison process, schedule a demo.