What is Capitalization Rate?

Capitalization Rate
March 17, 2021

It’s important to understand the meaning of capitalization rate (otherwise known as cap rate) if you’re interested in investing in commercial properties. The cap rate formula helps both buyers and sellers determine the value of a property. Let’s talk about what it is, how it is determined, and how it is applied.

Defining capitalization rate in commercial real estate

A commercial property’s cap rate is the ratio showing how its annual net operating income relates to its purchase price, usually expressed as a percentage. This number lets you evaluate properties in varying sizes, unit mixes, asset classes, ages, or rentable square feet on the same terms.

Cap rate is only used in commercial real estate—not in residential properties. That’s because homes derive their value based on comparable properties nearby that you recently sold. Commercial real estate, on the other hand, is valued based on how much income it produces. This income is a factor in the cap rate formula.

Calculating the capitalization rate

The capitalization rate formula is pretty simple: Divide the property’s net operating income or NOI by its current market value or asking price. The NOI refers to the annual gross income generated by the property minus its annual expenses. The NOI does not include capital reserves, mortgages, or any debt.

Here’s an example of how this formula works:

If a commercial property asset has an annual gross income of $4 million and expenses totaling $1.5 million every year, its net operating income is $2.5 million. If the asking price for the property is $3 million, then its cap rate is 8.3%.

The higher the cap rate, the higher the potential return.

How to use the cap rate when evaluating a commercial property

What’s great about the capitalization rate is that it allows you to compare commercial properties independently of how much they cost. With this formula, you can identify assets that offer a higher return on investment regardless of their purchase or asking price.

Let’s use an example to illustrate how you might use cap rate to evaluate two properties.

If an investment property’s asking price is $9.08 million and advertised to have a 6% capitalization rate, it should bring in 544,800 dollars in income every year. Meanwhile, another commercial property listed for $12 million and advertises to have a cap rate of 8% is expected to bring in $96,000 yearly.

You can compare the cap rate of these two investments to identify which one is worth investigating further. The capitalization rate is also used to develop an average market sale value at any given time. Factors like geographic area, asset class, location (whether urban, suburban, or rural), and property class (A, B, or C) all affect the average cap rate.

The average market cap rates help potential sellers and buyers gauge overall market price and figure out the average valuation for their properties. It can range from 5 to 9%. Some commercial real estate groups conduct cap rate surveys every quarter across major cities in the US and across multiple commercial real estate sectors to generate better insight into current market cap rates.

Limitations of the capitalization rate

The cap rate is dependent on the NOI, which the broker or seller typically provides. For this formula to be effective, you need to find out how the NOI was calculated—including which expenses were factored in.

If the property is actively performing, the capitalization rate is usually calculated using its current NOI. But if the asset is performing below standard with opportunities for improvement, the NOI is typically based on a projected or potential income—a number that the prospective buyer may not achieve. This is why it’s best to compete for the cap rate on the property’s current performance as much as possible.

Do note that the cap rate is just one of the many ways to determine the value of a commercial property. To get a holistic view of an asset’s real value, it’s important to also look at other elements such as cash flow, rates of return, and value-add potential, to name a few.

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