By Jay Chang
Cap rate, or capitalization rate, in real estate is one of the fundamental calculations for evaluating commercial properties. The cap rate represents the expected rate of return an investment will generate.
What Is Capitalization Rate?
Cap rate varies from market to market. It can be as low as 3 percent and as high as 10 percent, depending on the city. Different types of commercial properties also have different cap rates! For example, the average cap rate in the same city could be 4 percent for multifamily and 6 percent for retail.
Capitalization rate is calculated by dividing net operating income by the property value.
Capitalization Rate = Net Operating Income / Current Value
This means that for two properties producing the same net operating income (NOI), the property with the lower cap rate is valued higher than the other.
A property valued at 10 percent cap means that the property produces 10 percent return every year–even higher if the property is leveraged.
Sounds terrific, right? So, why wouldn’t everyone invest in markets with 10 percent cap then?
It’s actually not as awesome as you think. Here’s why you may want to avoid markets with high cap.
Risk Associated With High or Low Capitalization Rate
Although properties with higher cap rate generate higher cash flow or NOI, they are also harder to sell. This is because high cap is associated with less popular markets. (Think of Detroit.)
This may sound surprising, but markets with very high cap rates are usually riskier, because the property value and projected NOI may decrease in the long-term. On the contrary, properties in hot markets like Los Angeles and New York can be sold more easily, because there’s more demand. There are a lot of people buying or moving into these markets, which means the property value and NOI will continue to grow.
Another downside of high cap is apparent when doing value-add or development. For the same increase in NOI, the higher the cap rate, the less the property value appreciates. This means that renovating a commercial property in a high cap market gives you lower returns. This is why you see more construction and renovation in low cap markets.
How to Use Cap Rate to Analyze Deals
Cap rate is a very important metric when you’re buying or selling a property.
This is the average cap rate for that specific property type and class in the market. For example, a multifamily and an office building that are both Class B can have different market cap rates.
Also, a Class A multifamily property has a lower market cap than a Class B multifamily property.
This the cap rate you use when buying a property. If you’re buying a stabilized property, then the enter cap should be somewhat close to its market cap rate.
However, if you’re buying an underperforming property, then the enter cap may be much lower than the market cap. This is because there’s a lot of uncaptured potential in an underperforming property, so the buyer needs to pay a premium for it.
This is the cap rate you use when selling a property. This is a very crucial step, because it significantly impacts your sale price and therefore, your overall return.
Generally, you should be selling your property after it’s been stabilized, so you can use the market cap rate for reference. However, it’s very important to increase the market cap by five or 10 basis points a year for your exit cap rate.
For example, if the market cap is 5 percent at the time you purchased the building, then assume that you’re selling at 5.25 or even 5.5 percent in five years. This is to account for any economic downturn in the future. You want to be conservative and assume that the market is going to decline or slow down.
How to Find Reliable Data on Cap Rates
There are four main ways to access capitalization rate data:
- You can find cap rate surveys from the CBRE database
- Historical data are also available on LoopNet for free. You can search by property type.
- CoStar is also a great tool, but it’s not free.
- You can talk to local property manager or brokers, as well.
Whichever resources you decide to use, I encourage you to utilize two or more different reference points. It’s more accurate to use the average of a couple of different data sources—especially for something like cap rate that’s difficult to pinpoint.
Lastly, don’t forget to do a sensitivity analysis based on different exit cap rates when you’re doing your analysis. Good luck!
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