What's a Good Cap Rate for Commercial Real Estate?
The world of commercial real estate has a technical language all its own complete with complex terminology and equations. Today we're sharing an inside look at Capitalization Rates, also known as cap rates. From what they are to how they're calculated and what a “good rate” means for you—we’ve got you covered!
If you’re motivated to invest in a commercial property, odds are you’ve seen buildings offered at “10% Cap”, but what does that actually mean?
What is a Capitalization Rate in Real Estate?
A popular method to compare real estate properties by the potential return you can expect, a commercial property cap rate is the ratio of net operating income (NOI) to the property asset value.
The metric is specific to commercial assets purchased with cash and without financing. Measured as percentages, cap rates are determined by the real estate market and fluctuate widely based on:
- interest rates
- property class
- and availability
Across commercial real estate, you'll find most properties trade in a cap rate range of 3-20% with the risk being measured based on the amount of time it takes for you to recover your initial investment. For example:
>> If a commercial property is listed at $500,000.00 with an NOI of $75,000.00, the cap rate would be 15% (75,000.00/500,000.00 = .15).
>> If the investment is offered at a 10% cap, you could expect to yield a 10% return.
First-time investors all too often don't take cap rates under consideration when buying or selling their first commercial property—which ultimately impacts their cash flow and profit. The fact is, all investors need to understand the power of cap rates when making investment decisions.
Now let's explore how cap rates work, why they're important, and the many benefits of using the metric to earn you more money.
Why Commercial Property Cap Rates Matter
Now that you know what a cap rate is, why use it?
It's all about revealing the right investment opportunity for you! Cap rate percentages provide a quick and easy way to consider various commercial investment properties using an "apples to apples" comparison to assess potential cash flow.
There are a number of elements to consider when evaluating a commercial real estate asset for sale, and cap rates are one of the most important. A measurement to analyze your next commercial real estate purchase, cap rates provide investors with a preview at the investment opportunity presented by a property. You can choose to invest at different cap rates based on your risk tolerance:
- Low cap rates generally equate to higher property value and lower risk. Think of a stabilized property in a proven market.
- High cap rates indicate the property’s price is relatively low with the potential to yield higher returns—but that doesn't come without added risk. It can also mean the property has issues with vacancy, desirability, or maintenance.
Most effective when used as a comparison metric against similar properties, tracking cap rates from target markets also allows you to gain competitive intelligence that can be helpful in future benchmarking and analysis.
Keep in mind—not all investors look for the same factors. Approaches to acquisition vary. For example, some investors utilize heavy or light debt strategies while others prefer all cash. In any of those scenarios the actual amount of cash flow will change while the property still generated the same amount in annual revenue.
How To Calculate Commercial Property Cap Rates
Revealing a good cap rate doesn’t have to be complicated.
The cap rate for a commercial investment property is calculated by dividing the property's net operating income (NOI) by its purchase price or property asset value.
NOI/Current Property Value= Capitalization Rate
You can determine the net operating income by deducting management-related expenses from the annual income generated by the property like taxes and standard upkeep.
Current market value is the property’s value given the current market conditions. You can calculate current market value a number of ways:
- Price per square foot
- Cost approach appraisal
- Income approach appraisal
Commercial Real Estate Cap Rate Example:
A cap rate is the anticipated return if an asset were purchased in all cash. For example, if the property generates $700,000 in income after expenses and the current value is $7,000,000, then the cap rate is 10%. You’re earning 10% of your investment on an annual basis. With a cap rate of 10%, it will take you ten years to recover your initial investment.
Commercial real estate investments are valued based on the amount of income they generate for the owner, so as an investor you’re purchasing the stability of a property's cash flow.
When looking at the cap rate of a property, it's essential to understand that it reflects the current condition of the property. Changes can impact cap rates like building renovations, expired leases, or new lease terms. Now let's review a few variable conditions to consider when looking at cap rates in the context of commercial property investment.
What Factors Impact Cap Rates?
Accurately estimate an asset's potential risk and return with cap rates. Elements that drive and influence cap rates in commercial real estate include:
- Property type & class
- Credit scores
- Strength of tenant
- Lease lengths and expiration dates
- Replacement costs
- Timing of your acquisition
- Potential vacancies
- Expected returns
- Current market conditions
In the cap rate equation, a property's location is one of the primary driving forces behind its market value. Properties in larger urban centers (think San Francisco and New York) are typically priced higher than smaller areas. Considering their higher selling prices, cap rates in larger cities are generally lower. High-traffic locations also tend to command lower cap rates and higher prices than low-traffic locations because more desirable areas attract stronger tenants. This increases the stability of the property’s income stream and reduces tenant default risk. For example, a well-located commercial property in NYC is likely to have a higher sale price and lower cap rate than a similar property in Minneapolis. So, why will you see lower cap rates in expensive neighborhoods?
Property values increase at a higher rate, making it a more stable asset with lower risk to invest in.
Property Type & Class
You'll find various levels of risk associated with different types of commercial properties. Beyond implied risk, property classes are organized based on the building's quality, condition, and specific location. Each letter represents its own property class and associated cap rate.
Class A Properties
The best locations with premium finishes, Class A properties are the newest and likely to have the strongest tenants on long-term leases. That's why this type property is considered the most valuable and least risky—selling for the highest prices and lowest cap rates. The cap rates for Class A properties range from 4-8% depending on the property type and location.
Class B Properties
Class B properties offer a slightly less desirable location and more risk compared with Class A. Properties typically have solid tenants with some near term lease expirations and finishes may be dated. The cap rates for Class B properties range from 6-9% depending on the property type and location.
Class C Properties
Class C properties are generally less valuable and carry greater risk than Class B properties. They may have a secondary location and finishes could be in need of updates. They likely have solid tenants with some near term lease expirations and/or existing vacancies. Class C properties carry slightly more risk than Class B properties. The cap rates for Class C properties range from 7-10% depending on the property type and location.
Tenants with lower credit scores are generally at a higher risk of defaulting on a lease. Commercial properties with financially strong tenants typically command higher prices and lower cap rates than those with tenants with unknown or weak financial conditions. That's because those tenants are at greater risk of lease default, which reduces a property's value.
Strength of Tenant
The net operating income (NOI) of a property can fluctuate quickly with a change of tenants. For example, a preferred developer for a credit tenant or national tenant like Rite-Aid builds a space during a period of growth in a desirable area and the developer sells the project to an investor at a 7% cap rate, triple net. So, what's the issue here?
A credit tenant stays in a space for around 15-20 years, so the rate they're paying will be continuous (unless specified in the lease) over the 15-20 years. An investor could look at the commercial property and assume that it is a high-performing asset, but that may not exactly be the case for the next investor. The tenant is the real reason behind why the cap rate is 7%.
Timing is everything! If an investor buys the space at the wrong time, it's trouble. For example, if Rite-Aid vacates the building after their lease, you'll be forced to find another tenant who may pay a lower rent if the market rate is lower than it was two decades ago. Now that 7% cap rate triple net no longer applies.
Lease Lengths & Expiration Dates
Commercial rental properties with long-term leases typically command lower cap rates and higher prices than those with short-term leases. That means generating more consistent income for longer periods than short-term leases. In fact, shorter leases are higher risk because they represent the possibility that a tenant won't renew their lease and/or the renewal rental rate could be lower than the current one. On the flip side, leases below market rent value set to expire soon might be increased to meet current market standards, elevating net operating income (NOI).
The expense that would be incurred to rebuild a property from scratch and lease it to full occupancy is the replacement cost. Properties selling at or below replacement cost tend to command lower cap rates and higher prices than those selling above replacement costs. That's because there's less risk of market conditions compelling a new investor to build a comparable property from scratch and lease it at similar rates.
On the other hand, properties valued above the replacement cost have a higher cap rate, since investors could instead choose to develop a similar building.
Timing of Your Acquisition
A variety of factors could cause a change in a commercial property's expenses and revenue, including timing! Timing is a key factor when looking at cap rates and you can't expect the cap rate of a property to be continuous throughout your ownership. Cap rates are calculated annually, meaning the metric may fluctuate over time if operating expenses increase or decrease.
When considering commercial properties to invest in, it's important to take into consideration whether the space is fully leased. While you could be under the impression that an investment is safe with a low cap rate, if the space isn't fully leased then the NOI of the property would be significantly lower than if the property was fully occupied. Keep in mind, the more you stand to gain, the more you stand to lose as well.
Before you invest in commercial property, you want to understand your potential risk and reward. If a property is perceived to have higher risk, you'll want a higher return on investment (ROI), which means you'll pay a lower price. If the property is perceived to have lower risk, it may have a lower return, which means you'll pay more. Return expectations can shift relative to investment alternatives as well. For example, the interest rate on a 10-Year Treasury Bond is known as a “risk free rate" because it's as close as you can get to a no-risk return on your investment. Cap rates change relative to a risk free rate. If you can earn 5% on a 10-Year Treasury Bond, you'd want to earn a higher rate for the additional risk associated with buying commercial property.
Current Market Conditions
Understanding the current market cycle is essential when it comes to cap rates. Commercial property values typically tend to increase in a tight market, so cap rates decline. On the flip side, when we're experiencing a down market, prices are depressed so cap rates increase. In a bull market, investors may be willing to purchase property at lower cap rate—but will seek higher cap rates in a bear market.
Why is a Good Cap Rate Important?
A good cap rate allows you to make the most of your investment. Here's how: :
- Calculate risk and return
- Compare pricing on potential acquisitions
- Analyze refinancing options on your existing assets
- Consider long-term outcomes
Calculate Risk and Return
Cap rates provide you with investment insight into the risk you take on in purchasing commercial real estate, along with the potential return it could generate. Cap rates also serve as a key benchmark for you to compare against similar assets on the market, and to identify trends around both risk and return. Cap rates not only allow you to determine how much you can gain, but also how long it will take to recover your initial outlay.
Compare Pricing on Potential Acquisitions
As an investor, you make data-driven decisions informed by the best information available. Beyond better understanding risk and return, commercial real estate cap rates offer valuable insight into market trends. Comparing cap rates in the same market allows you to see how an asset stacks up against historical comps before you make your next investment. While lower cap rates indicate a property will generate solid income streams relative to their market value—higher cap rates reflect a higher-risk acquisition without as much income compared to cost. One method isn’t necessarily better than the other. Different investors look different criteria across unique strategies and approaches
Analyze Refinancing Options on Your Existing Assets
Want to restructure your current mortgage agreement? If you're interested in refinancing to save money, you want to take a close look at cap rates. Cap rates can indicate the value of a commercial real estate asset through a loan-to-value evaluation, which sheds light on whether refinancing is possible along with how it can offset repayment costs.
Consider Long-term Outcomes
If you want to deliver risk-adjusted returns in an uncertain market, tracking exit cap rates is a smart move. Understanding exit (or terminal) cap rates can help you project sales value. Outside immediate operating income from rents, you want to consider the long-term return of a commercial real estate property. While terminal cap rates offer the same essential function as standard cap rates, the formula is different. You divide NOI by the expected sale price to calculate an exit cap rate instead of using the current market value. For a deeper dive into the numbers, you can create investment models that take other factors into account like: purchase price, projected income and expenses, projected profit, senior debt, closing costs, exit price, and more.
What is a Good Cap Rate in Commercial Real Estate?
Calculating cap rates allows you to determine whether a real estate asset aligns with your individual investment goals. So, what exactly is a good cap rate in commercial real estate?
Fact is, the answer varies! Cap rates offer helpful market comparisons more so than isolated evaluations. You'll find a wide number of variable factors can impact whether or not a cap rate is considered "good" by any one investor. Influential factors like your investment strategy, expected return, risk tolerance, and asset class.
For commercial real estate—or any real estate, for that matter—there is no cap rate that is better than another because cap rates are all relative to the perceived risk associated with acquiring the investment property.
Whether a cap rate is “good” is influenced by an individual’s investment strategy and risk tolerance, the asset class (office, multifamily, industrial, retail), and the expected return.
For example, if one investor has a 10% annual return requirement, they would likely not be happy with an 8% cap rate. But another investor with a 6% annual return requirement would likely be just fine with an 8% cap rate.
Instead of looking at cap rates in a vacuum, you want to understand if the sale price aligns with your investment strategy. To do that, compare pipeline property cap rates against historical comp cap rates to help you determine how a potential opportunity aligns with your target risk profile. For example, a high-risk investor might consider a 15% cap rate in New York ideal. On the flip side, a low-risk investor could move away from higher cap rates, opting for deals with 5% cap rates that yield lower returns.
Average cap rates for commercial real estate assets generally range from 4% for ideally located assets of the highest quality to 12% or more for properties that may have financial, operational, or physical issues.
While there isn't a universal magic number when it comes to cap rates, you will find useful benchmarks across the three basic property classes we outlined earlier.
Average cap rates by property class:
Class A: 4-8%
Class B: 6-9%
Class C: 7-10%
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