If you’re investing in commercial real estate, one common term that you will inevitably hear, is “cap rate” – short for “capitalization rate.” It’s a term you need to know and understand prior to putting capital towards a deal. In today’s blog, Northstar’s Senior Analyst, Will Camenson, will cover what a cap rate is, what it means in regards to investing, and how it can impact investor returns.
What is a cap rate?
Cap rates are a “rule of thumb” that allow investors to quickly compare similar assets. A cap rate is essentially the yield generated by a property. When everything else is stripped out (debt, future sale, fees, etc.), a cap rate is the annual return an investor would receive on an all cash purchase. Mathematically, the cap rate for a property is rent minus expenses (NOI) stated as a percentage of the property’s purchase price.
If a property has an expected Net Operating Income (NOI) of $1 million annually and is valued at $10 million then the underlying cap rate is 10%. Additionally, it is useful to compare the underlying risk of a property, a 7% cap rate on one property versus a 9% cap rate on a comparable property in a similar location suggests that the 7% cap rate property comes with a much lower risk premium than the other.
Use the following formulas to determine the Cap Rate, Expected NOI, or Expected Value:
Another important feature of cap rates is the relationship they have to asset value. As cap rates fall, the assets value increases and vice-versa. This then begs the question - what do you want in a cap rate? The answer is - it depends. If you're investing in or buying a property, you would generally like to have a high cap rate because this equates to a lower valuation, whereas if you're either a landlord or selling the property, then you'd like to have a low cap rate because it means the asset's value is high.
While cap rates alone are not adequate to make an investment decision, they are generally the starting point when it comes to a commercial real estate transaction. In addition to cap rates it is also important to consider:
- The age of the property
- Tenant composition
- Tenant Diversity
- Lease roll-over and lease term remaining
- Market trends
- Economic fundamentals of the area
- Equity multiple
In summary, cap rates are a combination of many factors that affect the value of real estate. They are an integral part of evaluating a property, specifically, when laying it side-by-side a similar property in the same area. It's never advisable to solely look at one statistic when evaluating a property - it's always a good idea to take a holistic view, however cap rates are always a good place to start.
Today’s post was written by Northstar’s Senior Financial Analyst, Will Camenson. If you’d like to review Northstar’s current investor offerings, visit our investor portal at: https://invest.northstarcommercialpartners.com/