Commercial real estate investors will frequently speak of “cap rate,” i.e. capitalization rate, when discussing the present and future value of a property. In our humble opinion many investors/owners could stand to look at this metric more frequently.
An easily calculated formula, Cap Rate is a significant metric for the seasoned commercial real estate investor utilized to estimate potential and quality return or present or future value. Cap rate is best expressed as a percentage, the measure of which depends on the asset class of the property.
To calculate Cap Rate, divide net operating income (NOI) by the cost of the building. Cap Rate is then expressed as a percentage and will represent an owner’s return on investment. Some commentators and investors will expect Cap Rates between 3% – 10%, but in our experience, Cap Rate applicable to individual properties may be outside that range. Departures from that range, especially in the Philadelphia metropolitan market, may tell an important story about a property’s present, but not always its future. A Cap Rate example could be post-pandemic Center City office space that generates $400,000 in NOI but cost $9 million to purchase, will be yielding a 4.44% cap rate. An increase in rent (to $450,000) at the same purchase price yields a higher Cap Rate, at 5%. Yet, if that same property yielded the original rent, but cost an investor $10 million, the Cap Rate drops to 4%.
In determining value, a Cap Rate of a property is always a matter of comparison. What return would an investor expect from a different investment, U.S. Treasury Bonds for example? What is the risk differential between the investments? Is a higher risk worth the higher return? Is there room for improvement in the future, e.g., raising rents for expiring leases or filling vacant space? What future Cap Rate can be achieved? Is it worth risking the capital?
Calculating a present and predicting a future Cap Rate for a commercial real estate property is an important part of real estate investing. However, it is only one part of a large menu of elements to be considered when making a real estate investment decision.