Understanding Capitalization Rate in Commercial Real Estate

David Cohn
Sep 3, 2020
Commercial loans

A commercial property’s capitalization rate (or cap rate) is one of the basic measures investors look at to determine its potential value. Sadly, it’s still widely misunderstood.

What is it exactly? How do you calculate the cap rate? What are its limitations, and how is it best used when making investment decisions? In this blog, we will explain the capitalization rate in commercial real estate and how you can take full advantage of this metric for CRE investing success.

What is Cap Rate (also known as Capitalization Rate)

The best way to explain the cap rate is to use a hypothetical example.

Let’s say you are interested in two high-value commercial properties but can only purchase one of them. You want to look at their history and details to figure out which deal is best.

Assuming that both properties are in the same price range, the same condition, and in the same neighborhood, there’s only one thing left to look at:

Which of them is likelier to produce a higher ROI (return on investment), faster?

The cap rate is the metric used to determine the answer to that question.

If you’ve ever invested in any income-producing real estate asset, you have probably already calculated for capitalization rates before. You already know the formula:

Divide the property’s yearly net operating income or NOI by its costs. The result gives you a good means to compare how profitable the investment is.

You probably even read somewhere that the cap rate as a valuation metric has many advantages over others, such as Gross Rent Multiplier or GRM.

But hold on! The capitalization rate is not just a simple equation. To harness a more accurate sense of how fast your ROI can grow, you need to know how to make projections and factor “risk” into the calculation.

In this blog, we want to break down the vital factors that affect cap rate while dispelling long-standing misconceptions surrounding it and running through examples in which this metric is useful—and where it’s not.

How to Calculate Cap Rate in Real Estate

This is the cap rate formula in its basic form:

Net Operating Income / Current Market Value = Capitalization Rate

You will find several online calculators that you can use when calculating a commercial property’s cap rate.

How to Calculate Net-Operating-Income (NOI)

Figuring out a property’s annual net operating income is not as simple as it seems. It often requires a lot of explorations into both market and submarket activities, potential lease options, and operating costs, among many other factors that can potentially affect the investment.

The seller of the CRE asset you are considering should be able to show you the current NOI. But this is surface-level research and may not even be accurate.

Sellers have been known to artificially make the NOI bigger by collecting lump-sum payments from their tenants or by putting off routine maintenance work to prioritize physical renovations instead.

To truly see how profitable a property can be, you also need to figure out the projected NOI—and that means making educated guesses on questions like:

- If there are current vacancies, will you be able to fill them?

- Are the tenants reliable? Can they pay their rent promptly?

- How much will you spend on utilities? Is it possible to incentivize tenants to use them frugally?

It looks simple enough to figure out on paper, but the NOI is subjective in real life. It’s quite difficult to truly and accurately measure. Unless the seller is exceptionally trustworthy, getting an accurate NOI value—and therefore a precise cap rate—means doing lots of diligent research and prudent guesswork.

Figuring out a commercial property’s current market value

This is easy if the property is listed for sale with a list price attributed. But calculating the current market value can be difficult if this is not available—such as when the asset is considered an off-market acquisition.

To figure out the current value of such a property, you will need to use sales comparable. This data shows how much similar properties sell for and help you estimate the current market value of CRE asset under consideration. It is calculated by comparing recently sold properties on key criteria, including sales price, geography, age of the structure, and size/ square footage. There are online tools available for calculating sales comparable on properties.

Understanding Cap Rate Fluctuations

The fact that cap rates are affected by local, state and national market trends further complicates their calculation.

Commercial property values are widely affected by developments in the immediate locality—such as the rise in the number of new jobs in the area or new roads. Meanwhile, the NOI can be influenced by world events that seem far-flung—such as higher oil prices as a result of global conflicts.

Decisions made by the Federal Reserve and other fiscal, regulatory bodies also affect cap rates, albeit indirectly. For example, higher interest rates tend to drive property values down because they make maintaining a mortgage much more expensive.

This is why making educated investment decisions in the CRE industry is a highly involved process. There are so many factors at play, so it’s natural for even the most experienced and savviest of commercial real estate investors to second-guess themselves. You are not alone.

Where are cap rates heading?

Read any CRE investing blog, and you will see differing forecasts on the direction cap rates might take. There is a range of predictions and opinions—and many of them are grounded in the belief that property values follow a trend and that rents are set to decrease/increase.  

Again, capitalization rates vary depending on geography and asset class.

Don’t make the mistake of taking a hypothesis made for the US commercial real estate market and then applying it to, let’s say, industrial cap rates in Illinois.

Cap rates have been consistently low in recent years because we’ve been in an unprecedentedly long period of low-interest rates. But things may change.

The cost of owning commercial properties may rise and increase cap rates, ultimately driving down the value of individual CRE assets for owners and making conditions ideal for investors who are looking to buy.

How can property owners and investors prepare for such changes?

According to some CRE experts, owners may see 10% lower property values soon—and if they are considering selling in the next five years anyway, they might as well sell now. Experts are quick to clarify that this isn’t a “doom and gloom” forecast but go on to say that single-tenant, net lease CRE properties are likely to be the most affected because they have less ability to raise rents.

What is a good cap rate for commercial real estate?

Capitalization rates change, so the definition of a ‘good’ cap rate changes, too. It all comes down to relativity.

You can determine how good a cap rate is by comparing it against historical market rates. You might even say that an asset’s cap rate performs well despite the current CRE environment.

To understand relative performance, you need to look at market cap rates or similar properties' capitalization rates. Note that the measurement of any capitalization rate (and its performance) will vary depending on the location and property type.

Alternatives to cap rates

There are times when the cap rate metric is not the best tool to use for assessing a property.

Use a discounted cash flow analysis if you are dealing with a property with an irregular or complex net operating income and cash flow. This metric is better at determining a reliable valuation in this case.

Alternatives to the cap rate calculation include the Gordon Model and the Band of Investment Method.

The Gordon Model can be useful when you expect NOI to grow every year at the same constant rate.

Here’s the formula:

Cash Flow / (Discount Rate – Constant Growth Rate)

Note that if the growth rate surpasses the discount rate, this formula is no longer useful and should not be used.

Meanwhile, the Band of Investment Method looks at the return to both the investors/borrowers and the lenders in the deal. It’s a measure of the weighted average of the required return on equity and debt return.