Exactly what is cap rate in commercial real estate? How is it calculated? What’s a “good” cap rate? What are the pros and cons of evaluating an opportunity using this metric? Let’s discuss answers to each of these questions.

What is cap rate, and how is it calculated?

Cap rate is short for “capitalization rate;” it measures the rate of return that an investment earns. You calculate the cap rate of a commercial real estate investment using the following cap rate formula:

CAP RATE = NOI / PROPERTY VALUE

where NOI is Net Operating Income and PROPERTY VALUE is the property’s current market value.

To calculate cap rate correctly you must know–or accurately estimate–the net operating income generated from the property as well as the parcel’s current market value. Dividing income by market value yields a cap rate as a percentage.

Calculating a cap rate can easily be calculated off an iphone calculator or the “back of a napkin”. Say, for example, you were considering the purchase of a property in downtown Chicago with a market value of $2,000,000. The gross income is $325,000, and the operating expenses $125,000 making your net operating income (NOI) $200,000 . Your cap rate for the property would be 10%, or yield you a return at 10% of your initial investment.

What’s a good cap rate?

Is the 10% cap rate calculated above a “good” rate? The best answer is, “It depends.” Four big factors that affect a cap rate are 1) the location of the property, 2) the classification & age of the property, 3) creditworthiness of the tenant and 4) length of lease.

Property Location

Commercial properties are placed in one of 3 tiers based on how fully developed the area is.

Tier I locations are fully-developed cities like Los Angeles and New York
Tier II locations are still developing. Cities like Kansas City and Salt Lake City fall into Tier II.
Tier III locations have undeveloped commercial real estate areas. Charleston, South Carolina and Birmingham are examples of undeveloped commercial real estate areas.

Cap rates are generally lower in Tier I locations than they are in Tier II and Tier III cities. That’s one reason that secondary and tertiary markets are becoming increasingly popular commercial investment locations.

Property Classification & Age

Buildings are classed as A, B, C properties. The classifications are a bit fluid, but generally:

Class A properties are new or renovated, in excellent condition, and in premium locations. Fixtures are high-quality and the building looks impressive.
Class B properties often are found on the edge of an urban district or in the suburbs. They aren’t as new, neat or impressive as class A properties, but are better than Class C properties.
Class C properties are in less desirable locations, often need considerable renovation, and are usually older.

Creditworthiness of Tenant

The creditworthiness of the Tenant is a major driving force as related to the value of your investment. For example, a long term lease to a company like CVS, Fresenius Kidney Care, or Chase Bank will have a much lower cap rate than a lease with a local or regional operating entity. Should you require bank debt to acquire an investment property, your Lender’s underwriting team will likely inspect the Tenant’s ratings, balance sheet, and the corporate guarantee that comes with the lease affecting the terms and conditions of your loan.

Length of Lease

This is a simple concept, yet very important. The longer the term of the lease, the lower the cap rate. The risk associated as to what will happen after the tenant’s lease expires drives the value in lease. Be sure to understand that some lease agreements today have termination rights giving the Tenant the right to walk prior to the expiration date on the full term of the lease agreement. Your lender will likely underwrite the property to only the “firm term” of the lease.

Back to our example

Cap rates often range from 3% to 12%, with the lowest rates earned on Class A properties in Tier I locations. A cap rate of 4.00% might be a good rate if the property is in a posh location on a long term lease in the heart of Miami. In a market like Jackson, a 6.5% cap rate may be outstanding for a hard corner in a vibrant submarket with a national credit tenant. It’s important to understand the variables that drive the value so you can better evaluate the subject property no matter if you are on the buying or selling side.

What are the pros and cons of using cap rate as a real estate investment metric?

Pros

Cap rate is an easy metric to quickly evaluate an investment property.
Cap rates can be easily compared to other investments as you seek to select which property is right for you.
If you understand the variables driving the values behind this metric, you will likely be able to execute on timing with buying & selling investment properties.

Cons

Cap rate is just a basic calculation, but shouldn’t be the sole metric when analyzing investment properties. Other metrics like equity multiple, internal rate of return (IRR), cash-on-cash, and net present value (NPV) need to be analyzed alongside cap rate.
Cap rate measures a snapshot of a deal; not the life cycle of an investment.
Cap rate assumes a steady market with stable expenses and vacancy rate for an entire year. That assumption is rarely accurate.

Summary

Cap rate is frequently used by commercial real estate investors to compare between multiple purchase options. Although cap rate is an excellent tool, it needs to be used in tandem with other metrics as shown above. If you’re interested in learning more about how cap rates work and what drives the value behind this metric, be sure to reach out to one of our commercial real estate Mississippi specialists with your questions!