If you’re contemplating your inaugural investment in commercial real estate, one term that you probably keep coming across is capitalization rate, or “cap rate.” This term may seem somewhat esoteric, but it’s arguably the most ubiquitous criterion for evaluating an income-producing real estate investment — it’s also an exceptionally simple formula to calculate.
But we’ll get to that. Let’s start with a basic definition first.
What Is a Cap Rate?
“A cap rate expresses an anticipated annual return on an investment,” according to Jonathan Squires, managing director at Cushman & Wakefield.
How Is a Cap Rate Calculated?
In order to calculate a cap rate, an investor needs to be in possession of two data points: the asset’s market value or asking price and the property’s net operating income (NOI). A property’s NOI is established by starting with its annual revenue and subtracting annual expenses related to operating and managing the asset before debt service.
To determine the cap rate, an investor will divide the property’s NOI by the listing price of the asset, as reflected in the graphic below.
So, for example, if an investor was considering purchasing an industrial property for $2 million, and the subject property had an NOI of $100,000, you would divide $100,000 by $2 million, which results in .05, or a cap rate of 5%, as detailed in the below graphic.
Why Do Investors Use Cap Rates?
According to Squires, cap rates became dominant in real estate over the past several decades as the sector was increasingly institutionalized.
“As real estate has become more of an institutional investment, we've seen the cap rate become the first question that anyone has when looking at a property,” Squires said.
That’s because a cap rate is simple to calculate and enables investors to easily compare properties across asset classes and geographies. More importantly, a cap rate will help an investor understand the perceived or potential risk of owning a property.
A property with a higher cap rate will potentially produce a higher return, but it could also be more risky; on the other hand, a property with a lower cap rate might produce less income but offer greater stability.
Of course, Squires advises that the notion of “risk” in this instance is entirely theoretical. A cap rate is really a measurement of “the perceived risk” of owning a property, Squires noted; whereas “the actual risk is experienced while owning the property.”
How Reliable Is a Cap Rate?
While a cap rate can be a useful initial metric for a real estate investor, it’s certainly not the only calculation worth considering. That’s because there are numerous facets of owning a property that a cap rate doesn’t capture, including debt service and capital expenses.
Squires also advised that investors need to be wary of the cap rate that’s advertised by the seller of a property or by their agents. That’s because it’s generally difficult to determine what expenses are accounted for in the NOI that was used to calculate the cap rate that’s being presented.
As Squires acknowledged with a wry chuckle, “You could always estimate some cap rate; whether you believe it or not is another question.”
For instance, Squires said that many advertised cap rates will use low or no management fees, assuming the property will be “self-managed,” even if that’s an unlikely reality. They also may be using outdated tax figures.
Squires also noted that many listing brokers don’t properly account for “credit loss” or vacancy loss in their NOI calculations. Credit/vacancy loss refers to the period of time that a property is vacant after one tenant leaves and a replacement has yet to materialize, as well as the costs associated with securing that new tenant.
“Credit loss is a bit of an art,” Squires said, because it varies widely from asset to asset. For instance, a rent-stabilized multifamily property may have relatively little turnover and incur a credit loss averaging only 2% per year, whereas a retail or restaurant location may have more frequent vacancies, resulting in a credit loss closer to 10% per year on average.
Squires advised that even properties that are advertised as being leased on a triple-net (NNN) basis — which suggests that all of the property expenses are handled by the tenant, not the owner — can be somewhat misleading, as there are almost always some expenses that are carried by the property owner. “It's quite rare for something to be an absolute NNN,” Squires said.
As for the expenses that should be included in a property’s NOI, Squires suggested that in addition to vacancy loss and management fees, real estate taxes (current and projected); water and sewer expenses; common area maintenance, cleaning and electric expenses; administrative and reporting costs; and insurance premiums are all elements that should probably be included.
However, the approach to calculating NOI, and therefore estimating a property’s cap rate, will vary widely based on the type of asset, structure of any leases currently in place, local market predilections and the specific investor’s approach to owning and operating the property.
“An investor really needs to do their due diligence in order to make sure that the income is what is advertised, as well as the expenses. A cap rate that is derived from either faulty income or faulty expenses or both is not going to be an accurate measure that you can count on,” Squires said.
Cap Rate Alternatives
For investors inclined to dig deeper, Squires noted that a cash-on-cash yield represents an appealing alternative to a cap rate. A cash-on-cash return generally layers debt costs and capital improvement expenses into the calculation, which should give an investor a clearer understanding of the return they can anticipate from their investment each year.
It’s also worth noting the difference between the "going-in" cap rate and the "residual" or "terminal" cap rate of a property. The going-in cap rate is calculated using the net operating income in the year prior to acquisition, divided by the purchase price.
However, most real estate investors hold on to their investments for a number of years. In order to calculate the overall return on their investment, investors will have to make an assumption on the terminal cap rate they will achieve in the exit year, which will project the property's future sale price. This assumption is based on a number of macro-economic factors such as interest rate inflation, future market demand and rental rate growth. A terminal cap rate that is lower than the going-in rate often correlates to a profitable investment.
Perhaps the most basic technique for analyzing a real estate investment is looking at the price per square foot, which can be calculated by dividing the purchase price of the asset by the size, as measured in square feet, of the property.
Squires observed that looking at the price per square foot in coordination with the cap rate can foster an interesting perspective for a potential investor. “If a property has a low price per square foot, but also a low cap rate, it still could be attractive to an investor because they believe that the future value of the rents will be higher.”
According to Squires, most investors will look at all these metrics and more before purchasing a property. It’s important for investors to conduct their own analyses and not just rely on the information provided by the seller.
“Once you've learned how people are [presenting data], you can develop your own metrics so that you can do an independent analysis,” he said.
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