In this article, we’ll explore capitalization rate and its implications for property valuation and rate of return. Investors can use the cap rate to help determine whether to acquire a commercial rental property.
What Is the Capitalization Rate?
The capitalization rate is one of the chief pillars of commercial property valuation. Furthermore, it is easy (some would say deceptively easy) to calculate. Conveniently, capitalization rates uses just two inputs, net operating income (NOI) and the property’s current value. Like any equation, the capitalization rate you calculate is only as good as the inputs. However, you might have to estimate the inputs, especially when dealing with new construction. Therefore, developers also use other methods to estimate a property’s return and value. That way, they can gain a clearer picture of how much to spend on building or acquiring a property. They also can better estimate the expected return on investment (ROI) from the property.
Video: Commercial Real Estate – NOI, Cap Rate & Price
Cap Rate Based on Annual Returns
We should note that you calculate capitalization rate using an annual figure, NOI. This means that one year’s atypical results can provide a misleading result. In other words, an acquirer might misunderstand the property’s long-term NOI and the NOI growth rate. Therefore, it’s important, whenever possible, to calculate cap rate over several prior years for its true value and trend.
Cap Rate Independent of Financing
Because the capitalization rate formula depends on net operating income, it is independent of the financing method. That is, you would get the same NOI whether you acquired for all cash or borrowed 90%. The cost of financing is not part of the NOI, which means you can’t use the cap rate for cash-on-cash return. Rather, you must perform additional calculations to gauge the impact of leverage on your cash-on-cash return.
Cap Rate Calculator
The following is the a Cap Rate Calculator. You enter a property’s current market value and its NOI into the capitalization rate calculator to get cap rate. It also functions as a reverse cap rate calculator. Simply enter a cap rate and NOI, and it returns the current market value of the property.
How to Calculate the Cap Rate
The cap rate formula is:
Cap Rate = NOI / Current Property Value
Before we explore some examples, let’s discuss the two inputs.
Net Operating Income
As mentioned earlier, the NOI is an annual figure representing the gross rental income minus all reasonably necessary operating expenses. These expenses include:
- A loss reserve for vacancies and uncollected rents
- Maintenance and repairs
- Depreciation and amortization
- Property taxes (but not income taxes)
- Property insurance
- Common utilities
- Other expenses
You exclude from NOI costs that are capital expenditures, such as installing a new HVAC system. However, capital expenditures generate depreciation, which is an operating expense. Interestingly, this distinguishes NOI from EBITDA. EBITDA is earnings before interest, taxes, depreciation and amortization.
Gross rental income includes not only rent, but also parking fees, service fees and more. Coin-operated laundry and vending machines provide service fees.
Your leasing strategy can affect your expenses. For example, consider a triple-net-lease (aka NNN) property. There, the tenants pay for property taxes, maintenance and building insurance. Clearly, this reduces your operating expenses, but it also means that tenants might insist on lower rents. Therefore, the overall impact of your leasing strategy is situational.
As an example of NOI, consider a property grossing $1.2 million annually with $0.8 million in annual operating expenses. The NOI equals ($1.2 million – $0.8 million = $0.4 million) or $400,000/year. If operating expenses exceed gross revenue, you have a net operating loss (NOL).
Current Property Value
A property’s current value depends on current market values of comparable properties. You don’t use the book value for seasoned properties, as this gives unrealistically low values on older property. However, suppose you’re constructing a new building and don’t have good comparables. Then, you can use the cost of construction (less any interest charges) plus a markup to estimate market value.
Examples of Cap Rate Calculation
The following two examples illustrate the effect of capital improvements on capitalization rate.
Capitalization Rate Example 1
Imagine an older, 30-unit apartment building comes onto the market for a price of $1.7 million:
- Total monthly rent: 30 units x $500/unit = $15,000
- Monthly operating expenses: $6,000
- Monthly NOI: $15,000 – $6,000 = $9,000
- Annual NOI: 12 x $9,000 = $108,000
- Cap rate: $108,000 / $1.7 million = 6.35%
Capitalization Rate Example 2
Here, we use the same 30-unit apartment building. You estimate that if you spend $10,000 per unit ($10,000 x 30 = $300,000) on capital improvements, you can raise rents by $200/unit:
- Total monthly rent: 30 units x $700/unit ($500/unit + $200/unit) = $21,000
- Monthly operating expenses: $6,000
- Monthly NOI: $21,000 – $6,000 = $15,000
- Annual NOI: 12 x $15,000 = $180,000
- Cap rate: $180,000 / $2 million = 9.00%
As you can see, committing an additional $300,000 in capital will increase your capitalization rate from 6.35% to 9.00%.
Capitalization Rate Risk Premium
Another way to view capitalization rate is to think of it as a risk-free rate plus a risk premium. Conventionally, the risk-free rate is the yield on the 3-month Treasury Bill. The risk premium is additional return demanded by investors because of the investment’s risk. In the case of Example 2, let’s assume that the current 3-month T-Bill yields 2.4%:
Cap Rate – Risk-Free Rate = Risk Premium
9% – 2.4% = 6.6%
In other words, investors will require a premium of 6.6% over the risk-free rate to invest in the Example 2 project. Investors require the premium to compensate them for risks, including:
- Location, status and age of property
- Type of property
- Occupancy rate and rental collections
- Structure and terms of leases
- The market for similar properties
- Macroeconomic factors such as interest rates and the employment rate in the region
Factors That Affect Cap Rate
No factor is more important than location. It drives demand for a property and affects the local economy. All things being equal, a better location enables a higher market value for a property, thus a lower capitalization rate. Buyers desire to purchase properties with the as high a cap rate as possible. On the other hand, Sellers desire to sell their properties at the lowest cap rate possible! Consequently, you can charge higher rents when a property is in a desirable location. Of course, properties in good locations cost more to acquire. However, you can charge higher rents for units in these properties. Ironically, sometimes the higher value and higher NOI tend to cancel out, leaving the cap rate about the same.
Typically, commercial properties charge higher rents than do residential properties. The rent you can charge depends in part on the type of commercial property. These include office buildings, multifamily, apartment buildings, retail, recreational and industrial properties.
When supply is short relative to demand, prices go up. Certainly, this is true in real estate. If available inventory is in short supply, you’ll be able to charge higher rents. Conversely, if there is a supply overhang, you will find it hard to raise rents without triggering vacancies. This can lead to higher cap rates, meaning lower values.
Rising interest rates tend to reduce cap rates. The reason is that high rates creates a higher debt service and therefore decreasing cash flow.
Using the Reverse Cap Rate Formula
The reverse cap rate formula uses cap rate and NOI to calculate the market value of a property:
Current Property Value = NOI / Cap Rate
From Example 2, the NOI was $180,000 and the capitalization rate was 9.00%. The computed property value equals $180,000 / 9.00%, or $2 million. Naturally, this equals the sum of the acquisition price of $1.7 million and the renovation cost of $0.3 million.
You use the reverse cap formula to arrive at a buying or selling price for a property. Clearly, if you know, or if you can estimate the NOI, then the property value depends on the chosen cap rate. Typically, you would use the capitalization rates from comparable properties, which might require research to ascertain.
You can use the reverse capitalization rate formula to perform sensitivity analysis on rental property. In this type of analysis, you vary the cap rate to see the effect on property value. For example, in the following table, you can see how higher capitalization rates drive down property value. That’s because you need a lower purchase price to achieve the required rate of return on a high-cap-rate property.
When Not to Use the Cap Rate
There are several circumstances in which you would not use the cap rate:
- Vacant Property: Since vacant property doesn’t have any rental income, it can’t provide the NOI required for capitalization rate. You can estimate the NOI, but it might be incorrect, as it is hard to project expenses accurately.
- Land: Here too, there is no provided NOI. Instead, you can research the land for its zoning, condition and access to utilities. Also, you’ll need a complete survey of the land to know exactly what you will be purchasing.
- Fix-and-Flip: Rental income is not important for fix-and-flip rehabbers, because you want to sell the property instead. However, if you rehab commercial rental property, you will want to know the cap rate when negotiating selling price.
- Short-Term Rentals: Capitalization rate is an annual figure. You will skew the calculation if you rent out the property for only part of the year.
1) What is a good cap rate in commercial real estate?
Normally, you will encounter a capitalization rate between 4.00% and 10.00% for commercial property. Cap rates in high-demand areas will be lower than those in less densely-populated areas. Buyers prefer high cap rates because they imply a lower purchase price.
2) What is a good capitalization rate for multifamily?
You might expect to see a 4.00% to 6.00% cap rate for multifamily homes in high-demand areas. However, you might encounter cap rates of 9.00% or higher for multifamily property in low-demand areas. Much depends on the availability of competing units when applying the cap rate formula.
3) Is a higher or lower cap rate better?
As mentioned above, a higher cap rate is better for buyers, because of the inverse relationship to price. For sellers, a lower cap rate is better. The best situation is for a buyer to acquire a high-cap-rate property and improve it. This raises the property’s NOI and lowers its capitalization rate.
4) What’s the 2% rule in real estate?
It states that you should bid a purchase price in which monthly rent income equals 2% of the price. For example, a $1 million property should generate monthly rental income of at least $20,000. The rule is of little value, since it ignores the property’s condition and your net cash flow after expenses.