The value of a commercial real estate property is determined by the returns that potential buyers anticipate earning from it. The process of determining the market value of a property starts by calculating the Net Operating Income (NOI) and then converting it into a capital amount, which is known as the capitalization process.
Cap rate, short for capitalization rate, is a metric used to evaluate the potential return on investment (ROI) of a commercial real estate property. It is calculated by dividing the net operating income (NOI) of a property by its current market value or purchase price. The formula is as follows:
Cap Rate = NOI / Property Value
For example, if a property has a net operating income of $100,000 and a market value of $1,000,000, the cap rate would be 10%. This means that for every $1 invested in the property, the investor can expect a return of 10 cents in the form of net operating income.
Why Cap Rate is Not Always a Good Metric
While cap rate is a useful tool for evaluating the potential ROI of a commercial real estate property, it is not always the best metric to use. This is because it does not take into account the potential for renovation or redevelopment of a property. For example, if a property has a low cap rate but has significant potential for renovation or redevelopment, the actual ROI may be much higher than the cap rate suggests.
Before buying a commercial real estate property with the intention of renovating it and renting it out at market value to increase the exit cap rate upon selling, it's important to first check if the municipality allows this kind of renovation and rent increase. With current housing affordability challenges, municipalities are becoming increasingly protective of affordable rental units and small businesses, who may not be able to afford the increased rent. To combat renoviction, municipalities have implemented bylaws that limit building renovations and the allowable rent after completion. Therefore, it's advisable to consult with the municipality beforehand before making an offer on a property that has low cap rate but potential for renovation.
Cap Rate and Location
The cap rate can vary greatly depending on the location of a property. Coastal areas of the United States tend to have lower cap rates compared to properties located in middle America. This is due to the fact that properties in coastal areas are generally more desirable and have higher demand, which drives up prices and results in lower cap rates.
Live Example:
As the old saying goes, real estate is all about location, location, location. Here are a few examples of cap rates in coastal areas of the United States versus middle America.
| Building | Coastal Office Building |
|---|---|
|
Average Rental Rates
|
$3.5
$/SF
|
| Average Unit Size |
600
SqFt
|
| Number of Units |
86
SqFt
|
| Operating Expenses (% of Rev.) |
25%
%
|
| Vacancy and Bad Debt |
5%
%
|
| Net Operating Income | $200,000 |
| Cap Rate |
6%
%
|
| Value | $3,333,333 |
| Rent Growth |
4%
%
|
| Holding Period (yrs) |
5
Yrs
|
| Exit Cap Rate |
5%
%
|
| Exit Value | $3,333,333 |
| ROI | $300,000 |
Conclusion
Cap Rate is an important metric for evaluating the potential return on investment (ROI) of a commercial real estate property, however, it should not be the sole factor when considering a commercial real estate deal. This is because Cap Rate does not take financing payments into account. It only depicts the relationship between the income generated by the property and its value. Factors such as interest rates, loan terms, and amortization schedules can have a significant impact on the overall ROI of a property. Therefore, it's important to also consider other metrics such as cash-on-cash return, net income, and internal rate of return when evaluating a commercial real estate investment.