What is capitalization rate commercial real estate?

If you’re into real estate investing or thinking about getting started, you’re probably on the lookout for great deals on properties to flip or rent out. Knowing your real estate market well can make it easy to spot a winner. But, as you expand your portfolio, you’ll need a more sophisticated approach with solid metrics. That’s when the capitalization rate or cap rate comes into the picture. If you’re wondering what is capitalization rate (commercial real estate), we’ll tell you exactly what it means and how it’s calculated.

So, what is capitalization rate, commercial real estate?

The cap rate is a crucial tool for real estate investors. They use it to evaluate properties and find good deals. It’s a go-to metric in commercial real estate to show a property’s expected return on investment (ROI). That is to say, real estate investors use the cap rate to get a quick idea of what they might earn from a property. It also comes in handy for figuring out the selling price at the end of the investment period. 

The cap rate also tells you how long it’ll take to recover your real estate investment. For example, a 10% cap rate means it’ll take about 10 years to recoup your investment.

Keep in mind though that while the cap rate is great for comparing similar properties, there should be other things you look at. For instance, it doesn’t consider things such as types of loans, the changing value of money over time, or future earnings from property upgrades. These are important too. 

Is there a good example to explain the cap rate? 

As mentioned, the cap rate is a straightforward way to gauge an income property’s potential return on investment. It’s a key metric for investors when deciding whether to buy a property or not. 

It’s figured out by taking the property’s net income and dividing it by the property’s value, then expressing that as a percentage. A lower cap rate often means better value and lower risk, while a higher cap rate implies higher risk and lower returns. That said, property investors need to figure out the right cap rate for their risk tolerance. 

Let’s take an example to understand cap rates. Spencer has $1 million to invest and is considering two options: putting it in safe government treasury bonds with a 3% annual interest or buying an office building or a commercial building with multiple tenants. If he buys the building, he’d get $95,000 a year in rent but would spend $25,000 on maintenance and taxes, leaving him with $70,000 in net income. The building’s value stays at $1 million for the first year, so the capitalization rate is $70,000 divided by $1 million, which equals 7%. This 7% return is better than the 3% from treasury bonds, right? He gets the extra 4% compensating for the added risk. In such a case, it’s a smart investment decision. 

What factors affect the cap rate in commercial real estate?

There are a lot of things that can influence a property’s cap rate. Just like with other rental properties, the location is super important. Investment properties in busy areas usually have high cap rates.

You also need to think about the local market and what’s around. In bigger, more developed areas, cap rates tend to be lower because there’s more competition. Future trends, such as local market growth, can also impact the long-term cap rate.

Lastly, how much money you put into a property matters too. If you invest in renovations to make it more appealing, you can charge higher rents, which boosts the owner’s income and can affect the cap rate. 

What are the limitations of having a capitalization rate?

While the cap rate is handy for properties with a steady income, it doesn’t work so well if the cash flow is all over the place. For properties with inconsistent earnings, a discounted cash flow model might give you a clearer picture of your returns.

The cap rate is only as good as the stability of a property’s income over time. It doesn’t factor in future risks such as depreciation or big changes in the rental market that could shake up income. Therefore, investors need to keep these potential risks in mind when using cap rate calculations.

How to calculate the capitalization rate in commercial real estate?

There are a few ways to figure out the capitalization rate for commercial real estate.

The most common method is where you divide the property’s net operating income (NOI) by its current market value. So, it looks like this:

Capitalization Rate = Net Operating Income / Current Market Value

Here’s what you need to know:

• Net Operating Income (NOI) is the yearly profit you expect to make from the property after subtracting all the operating expenses or the total cost of running it. This includes property maintenance and property taxes.
• The current market value is what the property is worth today, based on the current market prices. 

Since property prices can change a lot over time, using the current market value generally gives a more accurate picture than sticking with the original purchase price.

There’s another method that uses the property’s original purchase price:

Capitalization Rate = Net Operating Income / Purchase Price

However, this method isn’t very popular for a couple of reasons. Firstly, it doesn’t give accurate results for old properties bought years ago at low prices. Secondly, it doesn’t work for inherited properties, since their purchase price is zero.

Is there an ideal cap rate for commercial properties?

There’s no one-size-fits-all answer to what makes a “good” cap rate. It really depends on how much risk you’re comfortable taking on. In general, a higher cap rate means more risk, while a lower cap rate suggests safer but smaller returns.

Typically, a cap rate between 5% and 10% is considered good. A 4% cap rate means lower risk but a longer time to make back your money. However, as an investor, you shouldn’t rely solely on the cap rate. Look at other factors too. For example, in the local property market, cap rates are based on future income estimates and can vary a lot.

Remember that different properties have different cap rates based on their risk levels. Properties with higher net operating income and lower valuations will have higher cap rates, and vice versa.

Therefore, there’s no clear-cut range for a good or bad cap rate; it depends on the property type and the market. For instance, two similar properties in different locations will have different cap rates. A property in a posh city center will generate higher rent but also come with higher maintenance costs and taxes, leading to a lower cap rate compared to a property on the outskirts.

Last thoughts

The cap rate is the go-to metric for judging how profitable a commercial real estate investment or a multi-family property might be. It shows the property’s one-year yield if bought with cash, not a loan. Basically, the cap rate tells you the property’s return rate without any debt involved.

The cap rate of a property is figured out by dividing a property’s net operating income by its current market value. This percentage gives investors an idea of what kind of return they might get from a real estate investment. It’s especially handy for comparing the value of similar properties.

Written by Ramona Sinha. December 30, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.