What is a Cap Rate for Commercial Real Estate Investments?
Real estate investment is a good idea given the financial conditions of other investment tools. With the stock market going up and down like a yo-yo, it’s nice to know there’s a place to invest that might be a hedge against stock market swings. Real estate investors understand there can be volatility in property ownership, however, investors find the valuations less volatile in challenging economic times. The question of what is a Cap Rate can be answered with a comparison to what other types of rate calculation methods for commercial real estate investments.
The Cap Rate is Key
The first question most real estate investment newbies ask is about the capitalization rate or “Cap Rate” for a piece of commercial real estate. The capitalization rate is the anticipated rate of return for a real estate investment property to generate. Commercial real estate investors don’t want surprises like the stock market provides and they want a way to determine what kind of return the investment in a particular commercial property will come back from their capital investment. The subject of Cap Rate drives most commercial real estate investment opportunities.
Calculating Cap Rate
The formula used to calculate the Cap Rate is to take the Net Operating Income divided by the property asset value. The resulting percentage number is used as a guideline toward determining the Cap Rate for the property. Net Operating Income for a commercial property is determined by adding up all rent payments and deducting all the expenses paid out by the property owner. Those expenses include insurance, property management, security, improvements, maintenance, and other overhead costs involved in owning the property. The math for the formula is:
Net Operating Income / Purchase Price = Cap Rate
Examples of Cap Rates
Different types of commercial real estate generate a variety of returns on investment. Cap rate is used to give a comparative value for comparable properties. The value of using capitalization rate calculations is found when comparing two or three properties of a similar description to each other. Real estate investors generally want to look at similar types of commercial properties when searching for an investment opportunity. Some examples of Cap Rate calculations are:
- Restaurant – Operating Income = $120,000/year less $20,000 in expenses yields $100,000 net income. The purchase price of the restaurant was $1,000,000. The Cap Rate is calculated as $100,000 / $1,000,000 = .10 or 10%.
- Mini-mall – Operating Income = $250,000/year less $50,000 in expenses yields $200,000 net income. Purchase price of the property including improvements was $1,000,000. The Cap Rate is calculated as $200,000 / $1,000,000 = .20 or 20%.
- Factory Site – Operating Income = $1,200,000/year less $100,000 in expenses yields $1,100,000 net income. Purchase price of the property was $10,000,000. The Cap Rate is calculated as $1,100,000 / $10,000,000 = .11 or 11%
Are Cap Rate Calculations Reliable?
Due to the simplicity of the formula, the Cap Rate percentage is not an accurate figure in all cases. It is commonly used as a quick reference to determine suitability for an investor to consider before conducting a more thorough investigation into investing in a property. The Cap Rate formula is useful as a quick-reference guide for investors to use as an initial qualifier for considering a commercial property to invest in. Other factors influence the final rate of return for an investment in commercial property, but for a quick and easy way to narrow down choices among comparable properties, the Cap Rate calculation is a great starting point.
Are Their Industry Standards for Cap Rates?
The good news is the Cap Rate can be easily used to compare potential rates of return on comparable properties. The bad news is there are no standards to determine if the rate of return on a particular type of commercial real estate versus a different property of similar nature is a valid measuring stick. Differences in property locations, future value considerations, and other factors affect the true rate of return. Some of the considerations not included by a Cap Rate are:
- The age, location, and status of the commercial property
- The type of property – multifamily housing, office space, industrial site, retail outlet or recreational property.
- The tenant’s payment history and prospect for receiving rents.
- The type of tenant agreement in place – rental, lease, or lease to own.
- The actual value of the property and any factors that may affect the valuation in the future.
- Regional and local economic conditions and issues that may affect the tenant’s business.
Commercial Real Estate versus Other Investments
Obviously, the higher the percentage number at the end of the Cap Rate calculation formula the better an investment a commercial property can be. What is important to consider is what rate of return other types of investments are generating for investors. Stocks, bonds, commodities, and other investments produce rates of return that attract investors, depending on the investor’s profile and desired returns. Investment in US Government Treasury Notes can yield between 3% and 5% return for investors. Stock market returns have traditionally averaged around 10% per year for stock investors. In commercial real estate, the returns vary due to differences in property types, locations, and the intrinsic costs associated with ownership. Compared to other types of investments, commercial real estate can outpace other investment tools, particularly in tempestuous economic times.
What is a Good Cap Rate?
As stated earlier, determining the Cap Rate for comparable properties makes sense because commercial real estate investors tend to own similar types of commercial real estate. Due to the variety of commercial real estate opportunities, the locations, and many other factors, it is difficult to come up with exact rates of return on investments. However, according to a survey of Cap Rates for different types of commercial real estate conducted by Motley Fool, the stocks and investments advisory service, there are some averages of Cap Rates for different types of property. As of December of 2019, the following Cap Rates are averages for investors:
- Urban Office Space – 6.67%
- Suburban Office Space – 7.91%
- Industrial Property – 6.27%
- Neighborhood Retail Space – 7.48%
- Urban Multifamily – 5.2%
- Suburban Multifamily – 5.49%
- Urban Hotel Property – 8.01%
- Suburban Hotel Property – 8.55%
The Implied Cap Rate
The implied Cap Rate is a different calculation than the Cap Rate. Implied Cap Rates deal with Real Estate Investment Trusts (REIT) and the way they invest in multiple properties. In other words, rather than investing in just one commercial property, an investor in REITs is spreading their risk over many properties. In addition to reducing overall risks for investors, REITs also help to develop commercial properties for their shareholders. Many REITs trade on the stock market and at present, over 87 million Americans are invested in REITs. The average return on REIT property investments runs between 3% to 16%, depending upon the investment group. An Implied Cap Rate is calculated as follows:
REIT Net Operating Income / REIT Market Cap = Implied Cap Rate
Cap Rate versus Return on Investment (ROI)
The calculation of Return on Investment (ROI) is similar to the formula used for determining a property’s Cap Rate. Return on investment involves including the cost of any mortgages or financing used by the investor to acquire the commercial property. This involves going one step further than the formula requires for Cap Rate calculation. For ROI, the investor has to deduct the cost of mortgage payments from the Net Operating Income derived from rental or lease payments. The remaining number is considered the property’s Cash Flow. Once the Cash Flow amount has been determined, the ROI formula can be utilized. ROI calculation is Net Income after mortgage payments divided by the down payment on the property to acquire ownership or:
Cash Flow / Down Payment = Return on Investment
Cap Rate versus Cash on Cash Rate
A Cash on Cash rate of return is based on the revenue generated from tenants compared to the amount of capital invested in the property to acquire it. The Cash on Cash method of determining the return on a property investment also uses the Net Operating Income number as well as deducts mortgage payments like the ROI formula, but it throws in the amount of vacancy for the property. The formula for the Cash on Cash calculation takes the rental or lease payments and deducts operating costs and mortgage payments from the total. The next step is to deduct the amount of income lost to vacancy. The final number, or Cash Flow, is then divided by the amount of capital invested in the property to acquire it. The formula then looks like this:
Annual Cash Flow / Total Capital Investment = Cash on Cash Rate
Cap Rate versus Internal Rate of Return
The Internal Rate of Return (IRR) is another calculation used by real estate investors to determine a property’s financial capabilities. This is a much more complex formula that is designed to consider the value of an investment over the life of the investment. Think of it like the Rate Cap is a snapshot of an investment and the Internal Rate of Return is more like a movie. Strictly speaking, the IRR is the rate at which the net investment equals the expected future income of the investment. The formula for determining the Internal Rate of Return is based upon coming to a point where the IRR is high enough to warrant an investment. In other words, investors dictate the rate of return they want and then start running the formula calculations to determine how much of an investment should be made. Instead of coming up with the rate, the formula has the desired rate inserted in it until the final number is zero. An example of this complicated mathematical formula is to start with the Year 1 Cash Flow divided by the desired IRR + 1 and then the same thing is done for each subsequent year until the total of each year’s calculation is added together with the initial investment amount deducted from the total and the result is zero. The formula looks like:
(Cash Flow Yr 1 / Desired IRR + 1) + (Cash Flow Yr 2 / Desired IRR + 1) – Initial Investment = 0
In this example, the IRR is the variable number that must be determined so that the result of the formula is zero.
Cap Rate is One Tool in the Toolbox
For real estate investors, the Cap Rate is just one of many tools available to them to understand the value of placing their capital into an investment opportunity. As a qualifier for conducting further investigation, it is an excellent starting place, but it can’t