Class Is In Session! Welcome To Cap Rate 101

Alright class. Today, we’re talking all about Capitalization Rate. And while this metric's got absolutely nothing to do with grammar, when it comes to its use in commercial real estate, you’ll most certainly want to mind your p’s and q’s.

Capitalization Rate, or Cap Rate as it’s known on the street 😉, is used to calculate the annual return on a property and gives insight into the value of that property. For an investor, it helps them easily compare multiple properties to determine the best investment. It can also provide insight into the fair market value of a given property when looking to sell. On the lending side of things, Cap Rate can tell us about the level of risk associated with that property and can be used to measure and manage those potential risks. Tracking the Cap Rate over the lifetime of a loan can help lenders determine how much they can expect to collect back from a property ­— which is important, especially in the instance that the borrower defaults on their loan. Yikes.

To calculate the Cap Rate of a property you’ll need to know the Net Operating Income (read more about that here) and the overall Property Value:

While this formula might not look very intimidating, I promise you, there’s a lot more here than meets the naked eye. Let’s walk through an example: say our property has a sales price of $1M dollars and an NOI of $100k. In that case, you’d get a capitalization rate of 10%.

What does that mean, exactly? As I mentioned before, the Cap Rate is the amount of return you can expect to get on a given property. That means the higher the cap rate the better the deal, right? Not so fast. The Capitalization Rate is also tied to the risk that’s associated with that particular property, which goes to say that it’s got an inverse relationship to the property value.

So typically, if you have a higher Cap Rate, you can expect to see a lower property value, and vice versa. In commercial real estate, high Cap Rates might mean that the property is located in a less than desirable neighborhood, or has a lot of maintenance fees due to the condition or the age of the building. If you have a property that’s located in a “low Cap Rate” area that might mean it’s in a great neighborhood, it’s a new building, or that it has a lot of appreciation potential.

Put more simply: the riskier a property is considered to be, the higher you’d want the Cap Rate to be. That ensures you’re getting a higher return on your investment to offset the higher risk associated with the property. And this checks out. Sure, you might be receiving a higher return, but you could also be spending a whole heck of a lot more on repairs for the building, or higher vacancy percentages due to unstable tenants. Conversely, the value of a property goes up when a property has a reliable tenant and/or is in great condition because it has a steadier income stream. There is less risk/work that goes into collecting rent on time or maintaining the condition of the building.

Generally speaking, anything between 4-10% is considered a good cap rate, however, this range is subjective because it can vary depending on someone’s investment or lending strategy.

Interpreting Cap Rate

While Cap Rate can tell us a lot about the value of the property, the associated risks, and the overall rate of return on investment, it’s not the only indicator of an investment’s strength. As a matter of fact, it falls short in that it doesn’t consider irregular operating costs/expenses or any value-adding variables. What’s more, is that the market Cap Rate can vary based off different factors like asset type, geographic area, submarket, and property class.  So, while the formula itself might be relatively simple, interpreting this metric is heavily nuanced.

It’s also highly sensitive to several different factors: Current market condition, current lease lengths, and in-place rents versus market rents can all affect the Cap Rate. The current market plays a large role in the property value which significantly affects the Cap Rate. In a down market, property prices drop causing Cap Rates to increase. In a high market, property values increase, and Cap Rates decrease due to the competitive nature of the market. The Cap Rate is also affected by rents because it is based off a property‘s in-place rent revenue. However, if a building has existing rents that are below market value, then the operator can increase the rent over time to better reflect the current market rents. This will increase the NOI of a property and therefore decrease the Cap Rate.

And there you have it: Cap Rates 101. You passed 🤓 Any further questions? Feel free to stop by my office hours, or drop me a note at laurabohlmann@blooma.ai.

Until next time friends.