The commercial real estate industry can be a risky business and using a terminal or residual capitalization rate, or cap rate, to measure potential risks in an investment opportunity. Determining what is a good cap rate for real estate can be a determining factor for the success of an investment.
A cap rate is designed to measure a property’s annual yield to compare and contrast the risk and return profiles. The cap rate is calculated by dividing a property’s net operating income, or NOI, by the purchase price of the commercial real estate property.
What Is a Good Cap Rate for Real Estate?
Cap rates are a valuable comparative tool designed to examine the risk of potential investment properties. Buyers and sellers regularly rely on cap rates to evaluate fair pricing practices and monitor commercial real estate market trends.
A terminal cap rate is used to measure a property’s yield in a one-year time frame to make it easier for comparisons of one property to another without taking into account the debt taken on by the asset. The cap rate is a property’s natural, unlevered rate of return.
Older properties typically have fewer tenants with great credit, presenting more risk and a lower valuation, resulting in a higher cap rate.
Terminal CAP Rate Measures Risk
At its core, formulating a cap rate is really a simple math problem, though it is better understood when thinking of it in terms of measuring risk. A higher cap rate generally is an indication of a higher risk, while a lower cap rate means there is less risk for the investment.
In addition to being concerned with returns and profits, investors need to pay attention to risk factors that increase the chances of losing money in the deal.
Factors That Affect Real Estate Cap Rates
For investors figuring out the right Cap rate for a property, determining factors include:
The old real estate adage that the top three most important factors are location, location, location, and the same applies to cap rates, as well. Location is the driving force behind demand fluctuations. Cap rates are lower for larger and wealthier populations that drive local economies. For example, cap rates are lower for the San Antonio metropolitan area then they would be for rural areas in northwest Texas.
Even within large metropolitan areas, cap rates can differ depending on the proximity to the downtown hub compared to the suburbs, which would have lower risks associated with the application or cap rates.
Interest rates and market demand are main factors that can affect the cap rate of a real estate property. Capital market benchmarks are typically used to analyze the cap rate of a specific property. Rising interest rates will affect the differential between financing rates and cap rates. As that difference compresses, the value of the property can go down.
A residual capitalization rate can fluctuate depending on the type and class of the property. Offices, industrial, and retail spaces will have different risk factors that will affect the cap rate. Multifamily residential properties have the lowest perceived risk with the lowest cap rates. Apartment vacancies are not as affected by a weak economy as other commercial properties. People need a place to live no matter what the markets are doing or how the interest rates are set.
Calculating Cap Rates
Yearly Gross Income of the Property
The gross income of a commercial rental property is primarily the accumulation of rent payments throughout the year. Income can also be accrued from revenue generated by such things as coin-operated laundry or food vending machines.
Subtract Operating Expenses
Operating costs for commercial properties can include such items as maintenance, insurance, taxes, utilities, vacancy costs, and property management expenses. The net
income of a commercial property is calculated by subtracting these operation expense estimates from the gross income amount.
Divide Net Income by Purchase Price
The cap rate is a percentage that is determined by the ratio between the property’s net income and either the original price of the property or the capital cost.
For example, if you purchase a commercial rental property for $1 million with an estimated annual rental income of $110,000. The total expenses for property management, insurance, taxes, and any other expenses, $40,000, for example, are subtracted from the rental income, yielding an anticipated operating income of $70,000.
When you divide that $70,000 operating income by the $1 million purchase price, then multiplying by 100, it gives you a cap rate percentage of 7 percent.
When to Avoid Using Cap Rates
While cap rates can be uses as incredibly valuable comparative valuation tools, it is just one factor in the decision-making process for real estate investments. Cap rates do not apply for some specific types of commercial real estate deals.
Cap rates are not useful for fix-and-flip properties or other short-term investments designed for a quick turnaround. Revenue is not generated from rent payments and cannot be measure through the determination of a cap rate.
The cap rate is not the same as a cash-on-cash return, which is calculated by dividing the cash flow amount after paying any debt service or mortgage payments by the total amount of cash invested. Both cash-on-cash and cap rate evaluations are valuable in determining any possible profits that will come from the investment. Cash-on-cash takes in account debt on the property while the cap rate does not.
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