All You Really Need to Know and More About Capitalization Rates

If you are a real estate investor, you most likely know something about CAP rates. If you’re not a real estate investor, you might want to know about the types of returns you can make on your money if you invest it in commercial real estate, and how to compare those returns to what you are earning in your savings or other investments. CAP rate is short for capitalization rate. It is one of several investment performance measures that real estate investors use to compare one investment with another. It us used to establish what an income-producing piece of property is worth. It is considered a return of and on your invested capital. It also is called an overall rate of return.

To some extent, the CAP rate reflects the risk of a particular investment. If the risk is low, so is the CAP rate. The higher the risk, the higher the CAP rate.

To compute a CAP rate, you start with the net operating income of the property. In general, the NOI is computed by subtracting the property expenses (before debt service or depreciation) from the gross scheduled income based on existing leases. After you have your NOI number, you divide that number by the price to get a CAP rate (expressed as a percentage). If you decide to play with this equation, you will note that the higher the price, the lower the CAP rate. The lower the price, the higher the CAP rate. Hence, an inverse relationship exists between price and CAP rate.

CAP rates vary from one part of the country to another, so there is a geographical tolerance inherent in the concept. Where there are a lot of investment dollars chasing a shortage of available properties, investors seem to be willing to settle for lower CAP rates than in an area where investment opportunities are plentiful.

They also vary from property type to property type. Multifamily apartments tend to have lower CAP rates than other commercial property types because they tend to be easier to lease up when there is a vacancy.

Demand tends to be high for apartments versus, say, office buildings. Triple net leases with national credit tenants and long-term leases often have lower CAP rates – again, a function of lower risk. Strip centers and office buildings with mom-and-pop type tenants often will generate higher CAP rates, which is a reflection of higher risk and less demand when a vacancy occurs.

When comparing one CAP rate against another, you will want to know what line items were used in the operating statement to arrive at that CAP rate. For example, it is common and proper to subtract a vacancy expense even if the property has no current vacancies. This is because you need to allow for some level of vacancy at sometime in the future. If a property is never vacant, this could mean rents are too low.
Another line item often missed in the computation of NOI is a management expense. If you intend to self-manage the property, you may be able to justify leaving out this line item. But it is a legitimate expense, and it reduces NOI and, hence, price.

Often a client will enumerate his or her investment objectives to us and will say “I need at least an 8% CAP rate.” That doesn’t mean we only look for 8% CAP rates. Why? Because a property offered at a 7% CAP rate, as an example, if bought for less money than the asking price, can end up being an 8% CAP rate. Some variation on that theme happens all the time.

Some investors don’t use CAP rates as their favorite benchmark for comparing properties. They have their own criteria, and as brokers, we roll with it.

If you have questions on CAP rates, don’t hesitate to contact us.

Written by Bruce Kaplan, Senior Broker associate with Premier Commercial Realty in Lake in the Hills.