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April 3, 2023

The Essential Guide to Commercial Real Estate Cap Rates

We previously discussed the income method as a primary approach in valuation, and cap rates were core to that discussion. In this brief, we discuss the various dimensions of this critical concept.

In our blog about CRE Valuation Tools, we analyzed various methods for determining the value of commercial real estate assets, with emphasis on the “Income Method.” In this article, we will explore the “cap rate,” or capitalization rate, arguably the most critical aspect to comprehend when employing the income approach.

The world of commercial real estate investing is full of buzzwords, jargon, and acronyms that can make little sense to those with a passing understanding of the industry. Commonly used by CRE investors, the term “cap rate” is a ubiquitous industry term, but when pressed, even consummate insiders find it difficult to provide a definition. The purpose of this brief is to clearly define “cap rate,” demonstrate how it is calculated and used, and why it is important.  

Let's dig in.

What is a Cap Rate?

The cap rate refers to the percentage rate of return an investor can expect to receive on a property based on its income-generating potential. The percentage reflects the ratio of a property’s net operating income (NOI) to the property’s value. In short, cap rate is calculated by dividing the property’s NOI by its current market value or sale price.  

For more information on NOI as another metric critical to estimating property values, you can find an entire article on calculating the net operating income of property here.

One uses the cap rate to evaluate the relative value or desirability of a particular real estate investment against another. Investors use this crucial metric to assess the profitability and risk associated with a specific property. The cap rate for a piece of property is essential to estimating the potential returns an investor can expect for that property. Typically, higher cap rates indicate higher risk, while lower cap rates indicate lower-risk investments. Let's put that in practical terms.

You see a property listed for sale at $500,000. You understand the net operating income (the money you can expect to receive from things like rent minus the expenses of upkeep on the property) on this property is $75,000. To calculate the cap rate for the property, you divide the NOI by the value: 75000/500000=0.15, or 15%.

This example uses simplified numbers for an easy demonstration, and 15% is an unusually high cap rate. Most CRE cap rates will be between 2% and 10%, though they can be somewhat higher or even lower, depending on various factors.

One detail critical to understanding cap rates is market variability and risk.

A property with a low cap rate will typically have a steady, reliable income, making it desirable and increasing its market value. 

Such assets can withstand market fluctuations with greater ease than those lacking these fundamentals, making them a more valuable long-term investment. Consequently, the property’s high sale value reflects its value to an investor.

Conversely, a property with a high cap rate can pay back its investment quickly, but this tends to reflect greater risk. Also, a cap rate can misrepresent a property’s comparable value and risk. Here's an example:

"The Mark Hotel is a 152-unit lodging property, also located on the Upper East Side of Manhattan in NYC. In 2017, the property was appraised for $427 million. After a tumultuous 2020 where NOI fell to a reported $2.1 million, the hotel rebounded in 2021 with an annual NOI of $27.58 million. Thus, the implied cap rate on the property rose to 6.51% from 0.51% in just one year. Hotels such as this are considered riskier assets as they have higher default rates than other property types but can offer a greater return on investment in the short term when economic conditions are fruitful." - Trepp.

As in the case above, spontaneous high-cap income may be unsustainable. If you were to invest in the property based on its high cap rate, but demand for the property drops (for example, due to another COVID surge), the temporarily high NOI would drop, leaving you with a worse investment.

Cap rates are helpful to investors because they provide an efficient, at-a-glance view of the dividend potential of a particular commercial real estate investment. Cap rates supplement other information necessary to make a solid investment decision, like factors in an individual investor’s profile, such as risk tolerance, financial resources, and one’s capability to weather downturns in the market.

Various investment strategies come into play when projecting actual realized returns from an investment. For example, suppose individual A’s investment strategy is to purchase properties only when A has available cash resources. In that case, one’s expectations on the return of a property will be different than individual B, who feels comfortable leveraging large amounts of debt to finance investments.

The most common mistake novice investors fall into when analyzing cap rates is thinking that a high cap rate is universally better. High cap rates reflect high potential but also high volatility. They can yield substantial returns but can also severely underperform against expectations, leaving an investment floundering. We often refer to this as the Cap Rate Trap.

Factors That Influence Cap Rate

The cap rate reflects the ratio between the value of a property and the net income of the property. Therefore, any change to one of those variables impacts the overall cap rate.

An investor might look for a property in an area targeted for future investment, assuming the investment property’s value will rise. Of course, the cap rate changes if the property’s perceived value rises or falls. Conversely, a property with a high value may lose value if the area suffers a natural disaster, the departure of a powerful company in the area, or another downturn in the region.

Net Operating Income, of course, is a whole calculation in and of itself. Many factors can change the income of a property, including:

  • Changing occupancy rates.
  • Changing rent.
  • Changing tax burden.
  • Changing expenses for ongoing maintenance, security, and utilities.
  • Required maintenance.
  • Deferring maintenance.
  • The expenses inherent in improving a property's value.

A change in any of these factors can influence the net operating income of a property and thus is reflected in the real cap rate of the property when those changes take effect.

Savvy investors will analyze a property and project the factors that might change cap rates over a medium to long-term time horizon. 

A property that appears strong at first glance may, in fact, have significant deferred maintenance, which can significantly reduce the property’s NOI upon acquisition, reducing its cap rate. Conversely, a property with historically under-market rents could increase rents when news of a local economic renewal project is announced. This will boost NOI and lower cap rate.

When is Cap Rate Not Useful?

The cap rate of a property reflects the current status of the property. Properties are listed for sale for many reasons. Sometimes, that reason is benign. Other times, the reason reflects the current owner’s assessment of future market conditions, selling before the onset of that change, which could negatively impact the value or cap rate of the property.

The conditions resulting in the current cap rate of a property are not guaranteed to hold under your ownership. Often, a change in ownership alone can be enough to upset the balance of tenants and expenses, such that the cap rate is immediately affected. That is, perhaps, one of the key lessons for a CRE investor to learn.

Leases can expire. 

An owner may decide to reposition and repurpose a property – say from cheaper retail to upscale retail – to change the overall value, the results of which vary wildly. Tenants can negotiate new lease terms, less favorable to building owners. Renovations and deferred maintenance may come due. All of this affects the realized cap rate of the investment.

Putting the Cap Rate into Context

Contextualizing the property’s cap rate is critical, a skill gained over time as a CRE investor. Knowing what to look for, as well as having a good mentor and good tools, can be helpful. Here are some ideas that can contextually shape the cap rate.

1. The strength or weakness of the current tenant(s).

The quality of a tenant within a property is a significant determining factor in its NOI. A hotel changing branding can change personnel, preexisting contracts, clientele, and other less visible influences. A retail space changing from one brand to another can have a similar impact. Changing from lower-priced retail to higher-priced retail – such as a change from Walmart to Whole Foods – can impact NOI. The issue is not simply a matter of the price of goods, either; while Whole Foods may make more income, it has higher expenses and may have significantly less demand depending on the location.

A property leased year-to-year can be highly variable. A significant part of this is the terms of a lease. A property leased over 10 to 20 years can be more stable initially. A shopping center or mall tenant with a longer lease  is traditionally referred to as an “anchor tenant.”

Imagine a scenario where a previous investor decides to sell their property, knowing that the current tenant's lease will expire in two to three years. You buy, expecting to maintain the status quo. The tenant decides not to renew the existing lease, which results in a vacant property. You can potentially fill the property with an even more valuable tenant, but conversely, market forces may mean no tenant is willing to step in for the price paid by the previous tenant.

The example of a departing anchor tenant is partly why properties with many tenants can be more valuable due to their stability. Of course, as evidenced by shopping malls throughout the country, demand must exist for businesses to want to occupy the property in the first place.

2. The timing of the purchase.

Cap rates are calculated with the value and NOI of the property as it stands at the time of calculation. Depending on its presentation, the cap rate can reflect changes in the market, including seasonal changes. Unfortunately, variability in calculation standards can yield non-reflective cap rates.

For example, things like deferred maintenance can impact cap rate calculations. An investor planning to sell in two to three years might delay or indefinitely postpone implementing repairs to the building to make the NOI look better to new investors, who will be in for a rude surprise when that maintenance comes due.

3. The occupancy of the property.

In multi-tenant properties, occupancy rates expressed as percentages can have a significant influence. 

Properties with high vacancy rates can boost their NOI if they launch an aggressive marketing campaign to attract new tenants (the bread and butter of commercial brokerages). Conversely, a property may presently be near capacity. But in the next two years, a significant number of existing leases may expire with no assurances that new tenants will fill these vacancies. With the increasing adoption of hybrid work, this scenario has become a looming concern for landlords and brokers in the post-pandemic period.

4. The location of the property.

Three things are critical in real estate: location, location, and location. Local market forces are more important than anything else in the viability of a CRE investment.

An early investment can be hugely valuable in a location poised for significant growth in the coming years. Conversely, an investment opportunity can dry up if the neighborhood loses residents and interest. For example, consider the growing tech interest in cities like Atlanta; or, in the opposite case, cities like Flint following the auto industry's collapse.

The Relationship Between Cap Rate and Property Taxes

One of the most significant expenses for CRE investors is property taxes. Property taxes can be assessed by state-level governments, local governments, and school districts, among other sources, and are notoriously tricky to monitor and forecast.

Where do these organizations get their information to calculate property taxes? Typically, an assessor examines many different aspects of the property. One significant aspect is the cap rate of the property. Thus, the cap rate – and, more granularly, the NOI and estimated value of the property – is critical in estimating property tax burdens, present and future.

It is challenging to calculate property taxes, especially forecasting them for future payments. We created itamlink, a comprehensive commercial real estate financial analysis, and forecasting tool to simplify this process. With many integrations to first-party data sources, intelligent reporting, forecasting, and assessment information, itamlink can alleviate much of the stress, errors, and potential problems of calculating property taxes.

Whether you need assistance properly forecasting your taxes and other financial burdens or you've encountered a problem and need data and reports to back up an assessment appeal, itamlink is an excellent tool. To learn more, request a free personalized demo today to see how itamlink can work for you. Your portfolio and your wallet will thank you.

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© 2023 Rethink Solutions. All Rights Reserved