When evaluating commercial real estate, investors use several pieces of information to assess the property’s value and potential ROI. One of the most popular metrics is the cap rate. Let’s explore this commonly used figure. We’ll cover the calculation and how to determine if it is a good cap rate for commercial real estate
What Is a Cap Rate?
The capitalization rate, or cap rate, represents a snapshot of a property’s anticipated rate of return on investment. The cap rate is a ratio of a property’s net operating income (NOI) and its value. This rate indicates the property’s potential profitability and its relative risk as an investment.
Calculating the cap rate of a property is simple. But, determining whether or not a specific rate is “good” will depend on a number of factors, particularly the local market and an investor’s personal risk profile. Weighing all of these factors is essential in properly using the cap rate metric.
How Cap Rate is Calculated
The simplest, most commonly used formula is:
Cap Rate = Net Operating Income / Current Market Value
In this calculation, the NOI represents the annual income generated by the property, less the expenses incurred for operating the property. Deducted expenses include property taxes, insurance premiums, maintenance expenses, and other costs of property management and facility upkeep. For purposes of calculating the cap rate, disregard any mortgage or financing debt associated with the property.
Current market value comes from the present-day value of the commercial property according to prevailing market rates. Alternatively, some cap rate calculations use the property’s original or proposed purchase price.
To summarize, cap rate calculation involves the following steps:
- Calculate the property’s gross income. For example, for a multifamily property, the gross income might include the sum of all rent and other revenue sources, such as late fees, parking fees, and laundry facilities.
- Calculate the NOI. From the gross income, subtract all operating expenses. Do not include any debt payments, depreciation, or capital expenses.
- Determine the property’s value. The value could be the current assessed market value, proposed purchase price, or an estimated value based on the calculated average price of at least three comparable properties.
- Divide the NOI by the property’s value.
- Convert the ratio to a percentage by multiplying the result by 100. This is the cap rate.
It is important to note that though the calculation itself is rather simple. But, determining NOI to use in the calculation is not necessarily so straightforward. Different investors might use different allowances for vacancies, which impacts the gross income. Similarly, different investors might include different expenses — such as capital expenses — or make adjustments based on how they might manage the property differently. Some calculate the NOI based on prior year historical information, while some annualize the most recent three months or use the NOI calculated from a pro forma for the first year.
How Do Cap Rates Work?
The cap rate allows investors to assess an investment’s potential profitability and to more easily compare possible investments. Investors commonly use cap rates as a way to quickly compare the relative value of similar commercial real estate properties and their anticipated return on investment.
For example, two properties of similar condition and square footage both have a price of $20 million. One property generates $600,000 in NOI, while the other produces an NOI of $1.4 million. The first property is a 3% cap rate; the second property at a 7% cap rate.
Property owners can use the cap rate calculation in comparison with their market’s average cap rates to assess whether their property is underperforming or exceeding industry averages. Cap rates are also useful when considering the sale of an investment property.
Rearranging the basic formula can help determine the property’s fair market value: current market value equals NOI divided by cap rate. You can thus calculate your property’s current value using your building’s NOI and the average cap rate for your property type and geographical region.
What is a Good Cap Rate?
“Good” is a subjective assessment, of course. Whether a cap rate should be considered “good” depends on a variety of factors. These factors include location, the real estate asset class, asset type, deferred maintenance, occupancy, and the investor’s planned exit strategy. Since cap rates reflect the perceived risk, an investor’s particular risk profile factors into consideration of target cap rates as well.
Average cap rates vary by region and by asset type. For example, a Class A office building in downtown San Francisco, California, averages 4.25 to 5%, while the same asset class in downtown Tampa, Florida, averages 6.5 to 7%. An industrial building in San Francisco averages 3.75 to 4.25%, while one in Tampa averages 5 to 5.5%. Thus, a “good” cap rate in San Francisco probably won’t be so good in Tampa.
The cap rate, though useful in assessing property risk and potential profitability, should not be used alone. It should be used in combination with other metrics and considerations.
Try Prospect Now
ProspectNow’s property databases contain a wealth of information useful for calculating cap rates for commercial real estate. Whether you are researching market comps or looking for your next commercial real estate investment, you’ll find reliable data on the ProspectNow platform.
If you’re looking for a real estate tool to inform your investment decisions, ProspectNow has been in the business since 2008. ProspectNow’s platform will enable you to make smarter real estate decisions and move through every transaction with confidence.