The capitalization rate, or often known as cap rate is a highly used tool in real estate markets–namely commercial real estate, such as office buildings, hotels, or warehouses–to determine the potential rate of return that is expected to be generated on a real estate investment property.
Cap rate represents the yield of a property over a one-year time horizon with the assumption that the property is purchased by cash rather than a loan. The cap rate can quickly help compare and analyze the relative value of similar real estate investments in the market.
Additionally, the cap rate indicates the amount of time it will take to regain the investment in a property. For instance, a property that has a cap rate of 8% will take approximately 8 years for recovering the investment.
While the real estate market can often be intimidating, understanding and utilizing cap rate as an essential tool can help improve your investment strategies to maximize profitability and return potential.
How to Calculate Cap Rate
First, to calculate what the cap rate is, simply divide the net operating income by the property asset value–the number generated is expressed as a percentage. The net operating income (NOI) is the expected annual income generated by the property after subtracting all the expenses. The current market value of the asset is the present-day value of the property. The formula goes as follows:
Capitalization Rate = Net Operating Income / Current Market Value
Consider you want to invest in a commercial building that is valued at $900,000 that has multiple tenants who are expected to pay regular rent. The total rent received per year is $100,000. The cost of maintenance and property tax is $20,000.
Step 1: Calculate the net operating income
NOI= $100,000 – $20,000
NOI= $80,000
Step 2: Determine the current market value:
Assume the value of the building increased to $1,000,000
Cap rate= $80,000/$1,000,000
Cap rate= 8%
Your cap rate is 8%. The question that now comes to mind, “Is this good or bad”?
What is a Good or Bad Cap Rate?
Given that cap rates are based on the potential estimates of future income, the cap rate is rather inconsistent in which it can either increase, decrease, or stay the same. Since the cap rate can fluctuate, there are no clear ranges for a good or bad cap rate. Whether or not the cap rate is good or bad, largely depends on the context of the property and market.
Although, there are resources where you can explore current cap rates to help you foresee where you might want to invest.
Factors That Affect Cap Rates
Even though your cap rate is contingent, there are 4 major factors that affect cap rates that can help you determine whether or not you want to invest in a specific property.
1. Demographics
On the one hand, buying a property in a major metropolitan area, for instance, Los Angeles or San Francisco has a higher demand because people are constantly moving in, around, and out of the city. Los Angeles and San Francisco are highly populated with very little land to go around. Major cities such as these are prime locations to invest in property. On the other hand, buying a property in a rural small town has higher risk factors since these locations are not as economically strong nor do they rarely attract a higher number of renters compared to major cities.
2. Location
Within the same markets: Commercial real estate buildings are organized into four classes (A, B, C, D) depending on the location and condition of the building. In short, there is a rating system for real estate locations. The higher the ranking (A) means better location and vice versa. Even though cap rates increase as you move to lower property classes; this does not necessarily mean it would be a bad investment, moreover, it will help you have a better understanding of the risks you may run into.
3. Property Type
Property types such as multifamily, industrial, office, and retail all have different cap rate percentages that result in various risk factors for each. While you do your research, you will notice the variance in cap rates and pricing trends among the property type.
4. Tenants
Ensuring the creditworthiness of your tenants will help reduce your risk in terms of having timely payments. Additionally, the length of your tenant’s lease will also have an effect.
Back Bay Investment Group is a leading real estate syndication company that focuses on commercial and multifamily asset classes. Our longstanding partnerships, relationships, and expertise allow us to generate superior returns on our client’s investments. Check out our blog section for more industry insights and contact us to get started with your real estate syndication efforts.
