With commercial property valuations in the news lately, the importance of getting them right has been placed firmly in the spotlight. Investors and developers in this property category need accurate estimates of what kind of return can be expected and what the correct value of a particular property is. Capitalizing annual net income is one method used, and understanding capitalization rates is all-important.
The capitalization rate, or cap rate, is a vital factor that investors must analyze. It is a measure of a property’s potential to provide an acceptable return on investment and is used in calculating the market value or, in a buying negotiation, the purchase price of a property.
While the cap rate is one of the factors that investors will use in their analysis of a commercial property, it’s not one that they have any influence over. It is used in a simple calculation, which I’ll explain in detail. It is vital, for example, when comparing the investment potential of two competing properties. I’ll explain what it is, how to calculate it, and how it can be used to make informed investment decisions.
Understanding The Cap Rate In Commercial Real Estate
In simple terms, the cap rate gives the investor a figure, which is the ratio of income to cost, expressed as a percentage. It is, therefore, an indication of the return that can be expected. Now, let’s get into the details.
What Is A Cap Rate In Commercial Real Estate?
The cap rate, as mentioned, is a simple ratio that can be calculated and then compared either to the accepted cap rate in the area or to the cap rate offered by another building under consideration. In that way, the investor can determine whether a particular property is a good investment.
How To Calculate Cap Rate In Commercial Real Estate
There are two factors in the calculation to establish the cap rate, so the equation is:
CAP RATE = NET OPERATING INCOME (NOI)
CURRENT MARKET VALUE or PURCHASE PRICE
Net Operating Income is the total revenue generated by the commercial building (usually the rental paid by tenants plus items such as parking fees for casual parkers) less the total operating costs, including maintenance, repairs, taxes, insurance, security, management fees, and cleaning costs.
Current Market Value: If the investor is trying to assess a price to offer for the property, itmay be calculated using a given cap rate and NOI in the above equation. If the market value is the variable the investor is trying to establish, it’s good to have a definition of precisely what that is:
Market Value is the price a willing, able, and knowledgeable buyer is prepared to pay a willing seller in an active, open market.
Cap Rate: If the investor has been given the purchase price and the NOI, the cap rate can be calculated to discover whether the asking price is market-related.
What Is A Good Cap Rate In Commercial Real Estate?
Analyzing and understanding cap rates in commercial real estate is key to successful investments. Generally speaking, a lower cap rate indicates the property is in a stable, low-risk area with strong tenants and a high market value. High-risk commercial real estate, conversely, will offer a higher rate of return and a higher cap rate as a reward for the investors’ risk-taking.
While cap rates in commercial real estate can range from 3% to 20%, experts generally agree that rates between 5% and 10% represent a sound investment and a reasonable balance between risk and return.
Factors Affecting Cap Rates In Commercial Real Estate
Cap rates are influenced by several micro- and macro-economic factors specific to the building and, more generally, regarding the area and the overall economic conditions in which the building operates.
- Location: commercial properties in high-demand areas tend to have a higher market value and, therefore, a lower cap rate than those in less sought-after areas. The income is more secure, and the potential for growth is greater, so investors will be prepared to accept a lower rate of return.
- Tenant Mix: The quality of tenants in a property will impact the cap rate. If tenants are unreliable, on short-term leases, or paying below-market rentals, investors will require a higher cap rate than a property with stable tenants and full occupancy.
- Market Conditions: In a strong market, the potential for steady increases in rental income and in market value will result in a lower cap rate than in a weak market with greater risk and less growth potential.
- Condition of the property: Older buildings that have not been well-maintained have a higher risk of repair and renovation costs escalating, reducing the net operating income and resulting in a higher cap rate.
Considering all these factors is essential when an investor has to calculate the potential profitability of commercial real estate and highlights why understanding the cap rate is such a vital part of investment decision-making.
Limitations Of Using Cap Rates In Commercial Real Estate
While the cap rate is a valuable tool in comparing the investment potential of two or more commercial buildings, there are more accurate means of assessing the true value of a property.
- The figures used in the calculation of the cap rate are for the current year only and don’t take into account future growth, market trends, and potential changes in future net income. So, the value it arrives at is more of a ”snapshot” picture than a forecast of future profitability.
- The cap rate calculation also doesn’t take into account many of the costs incurred during an acquisition, such as depreciation, finance charges, mortgage payments, and brokerage fees. All these will impact the profitability.
Other Methods Of Assessing Value In Commercial Real Estate
The cap rate is used by banks and valuers in assessing the viability of commercial real estate when granting mortgage loans, but for investors looking at long-term risk and return, there are other methods of calculating the feasibility of a potential property, which should also be used.
Internal Rate Of Return (IRR)
This method of assessing the return on investment takes a long-term approach to the income stream, looking at it over the life of the investment and including the costs of finance and depreciation to arrive at a net current value.
Replacement Cost Analysis
The value of commercial real estate can be assessed in purely physical terms by estimating the cost of building the property and adding that figure to the price of the land on which it stands. The figure is then adjusted for depreciation to arrive at present value.
Comparable Market Analysis
This method of assessing value involves compiling data from the market regarding recent sales and properties at present on the market that are similar to the subject property in terms of position, size, usage, and condition. Adjustments are made to take any material differences into account. Then, an average of all the individual values is calculated to arrive at a valuation figure.
Conclusion
While it is not the only way to assess the value of commercial real estate, the cap rate is a vital tool used by financial institutions and investors to make informed decisions. For this reason, it’s essential to understand the method for calculating a cap rate and how it is used to compare competing investment possibilities in commercial real estate.