Are you interested in buying commercial real estate (CRE)?
If you are, capitalization rate ("cap rate") is one of the most important terms to know. The cap rate helps you determine the value of a commercial property and is essential to know when buying or selling CRE.
What is a capitalization rate?
A capitalization rate is the ratio of a commercial property's annual net operating income to its purchase price. It's typically shown as a percentage. Cap rate lets you evaluate commercial properties in varying asset classes, sizes, unit mixes, rentable square feet, or ages on the same terms.
So why isn't cap rate used in residential real estate? Because homes are valued based on similar nearby comparable properties that have recently sold. The value of commercial real estate is based on the income it produces, so cap rate is more common.
How to calculate capitalization rate
To calculate the cap rate you need the net operating income (NOI). This is the property's annual gross income minus annual expenses. The NOI doesn't include any debt, such as a mortgage or capital reserves, that may be held for the property.
To derive the cap rate, divide the NOI by the asking price or current market value of the property.
If a property has a gross income of $400,000 and expenses of $150,000, its NOI is $250,000. If the property is listed for sale at $3,000,000, the cap rate would be 8.3%.
Why is cap rate useful?
Cap rates let you compare commercial real estate properties independently of the purchase price. You can identify which would offer a higher return on investment regardless of the cost.
The higher the cap rate, the higher the potential return.
For example, a property may be listed for sale at $908,000 and advertise a 6% cap rate, while another can be listed for $1,200,000 and advertise a cap rate of 8%. The first property is expected to bring in $54,480 in income every year, while the second aims for $96,000.
Buyers can compare two investments based on their cap rate to help identify which investment is worth investigating further.
When to use cap rate in commercial real estate
Cap rate is most commonly used when a commercial property is being bought or sold. It can be calculated using the current performance of the property or future pro forma projections.
Commercial real estate sectors also use the cap rate to derive an average sale value for the market at a given time. The average cap rate will vary by:
- asset class,
- geographic area,
- the location such as a suburban or rural, and
- property class (such as a class A, B, or C).
Average market cap rates can help potential buyers and sellers gauge the pricing of the overall market and determine the average valuation for their property.
Average cap rates can be anywhere from 5% to 9% depending on the market, property class, and commercial real estate sector. CBRE Group, Inc. conducts a quarterly cap rate survey across several major cities throughout the United States and across multiple CRE sectors to help provide better insight into market cap rates.
Potential problems with cap rates
The cap rate and NOI are typically provided by the seller or broker. So you need to know how the seller calculated the NOI, including the expenses included. Expenses vary by seller and property, so it’s up to the prospective buyer to review the provided expenses and compare that to their estimated costs for the property.
If a commercial property is performing, the cap rate is typically calculated using the current NOI. However, if the property is performing below market standards and has an opportunity for improvement, brokers often base their asking price on the potential pro forma NOI.
The pro forma NOI is simply a projection, and the prospective buy may or may not achieve that number after purchasing the property. For this reason, it's typically best to evaluate a property based on its current performance.
Cap rate is one way to determine commercial property value. Although it's helpful to discern a property’s performance or potential performance compared to that of other properties, it shouldn't be the only factor that goes into analyzing the investment.
The internal rate of return, cash flow, and value-add potential are other factors that may be used to help evaluate a CRE investment.