Cap Rate in Commercial Real Estate | JT Capital
Learn why cap rate matters in commercial real estate and how it helps evaluate investment opportunities in this quick, helpful guide.
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The Importance of Cap Rate in Commercial Real Estate
Cap rate measures the expected return on a commercial real estate investment by dividing net operating income by market value. A higher cap rate suggests higher potential returns but also greater risk. The ideal cap rate typically falls between 4-6% for balanced risk and reward. Book a meeting to explore investment opportunities!
The goal of investing in commercial real estate is to earn a consistent and positive return. Of course, real estate market conditions on the micro and macro levels influence the actual returns investors enjoy. However, a thorough and logical review of a property can put investors in a better position to find a positive result.
One of the single most important metrics in commercial real estate is the capitalization rate, commonly called the cap rate. Let’s take a closer look at what the cap rate in commercial real estate is and how savvy investors use it to evaluate potential investments in commercial properties.
What is the Cap Rate in Commercial Real Estate?
In commercial real estate, the cap rate refers to the expected rate of return on an investment, as Investopedia explains. It’s generally expressed as a simple percentage. For example, a property might be referenced as having a 3.5% cap rate or a 9% cap rate.
The cap rate formula – the process used to find that percentage – isn’t very complicated, at least on the surface. It’s a simple rate calculation that divides the annual net operating income (NOI) by the market value of the property in question.
As a reminder, here are brief definitions for both NOI and property market value:
Annual Net Operating Income: Annual NOI is the yearly amount of money a property (or any business or asset) generates after accounting for operating expenses. It’s also called net profit.
Property Market Value: Property market value is the likely and expected price of a property in an open, fair, and competitive market. It assumes a fair sale for buyer and seller, and that the buyer and seller are both informed and acting in their own best interests.
So, calculating cap rate is simple. It yields an easy-to-understand percentage that helps investors understand their expected rate of return for a given property. However, cap rate also represents potential risk – this is fully explained in the next section of this guide.
However, because cap rate only takes a few key figures into account, it needs to be understood in the right context.
J.P. Morgan Chase shares some of that context, noting that comparisons using cap rates should be made between similar properties. That’s because a wide range of factors influence cap rates in commercial real estate, from a property’s location and condition to the quality of tenants and a variety of macroeconomic forces.
In other words, cap rate is useful and often very helpful, but it’s not a metric that can be used by itself to completely and fully evaluate a possible real estate investment. Savvy investors also look at the local real estate market, larger economic factors, interest rates, and much more to better understand the potential for positive returns.
What is a Good Cap Rate? Is a Higher Cap Rate Better than a Lower Cap Rate?
A good cap rate is subjective. That may seem strange at first, considering that the cap rate shows the expected return on investment for a commercial real estate property. However, the cap rate represents potential risk as well as expected return.
A high cap rate indicates the potential for a high return in an investment property, but also indicates less stability. This could be due to the condition of the building, the quality of the tenants, and several other factors either individually or, more often, in combination with each other.
A high cap rate generally indicates the potential to earn more from the investment, but also that the returns are less stable.
It may be harder to find reliable, high-quality tenants if current tenants leave a property with a high cap rate, for example. As another example, the property might need significant maintenance and repairs in the future.
These factors drive down the market value of the property, increasing the cap rate and the potential for higher net income. But they also could lead to increased expenses for the owner, making the investment more risky.
So, it’s better to look for the “sweet spot” in cap rates as opposed to especially high cap rates. Cap rates in the general range of roughly 3-7% tend to balance risk and reward in a way that’s favorable to investors more so than very high or low cap rates.
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