What Is a Cap Rate in Commercial Real Estate?
Commercial real estate is any property that is leased or owned for business or income. It includes office buildings, shopping malls, industrial buildings, retail stores, and more. Investors considering investing in commercial real estate will want to evaluate the risk of purchasing a commercial property. In other words, how profitable is their investment worth in a year or a defined period? To analyze this financial projection, the investor will examine several different metrics of property valuation before deciding to invest. Capitalization rate or "cap rate" is a crucial metric of commercial real estate valuation. Commercial real estate professionals commonly use cap rates as an easy and quick way to calculate property value. However, the cap rate valuation method has its limitations.
What is Capitalization Rate or Cap Rate?
In a commercial real estate valuation, the cap rate estimates the potential return on a real estate future investment in the first year of an all-cash investment expressed as a percentage.
How to Calculate Cap Rates in Real Estate?
To determine the cap rate of a commercial real estate, take annual Net Operating Income (property income less property operating expenses) and divide it by an all-cash purchase price the investor expects to pay for the commercial property. The formula used to calculate it is:
Capitalization Rate (Cap Rate) = Annual Net Operating Income⁄Purchase Price
The higher the cap rate, the higher the potential return, the lower the property price, and the higher risk for the investor. The lower the cap rate, the lower the projected return, the higher the property price, and a low risk for the investor. Investors are more likely to pay more for low-risk property (high-demand areas) with greater chances to continue appreciating and generating more income.
Other factors weigh heavily on the calculation of a cap rate. “Lease Term Length” is one of the largest. While a publicly traded company being the tenant of a commercial real estate property being offered for sale, is attractive due to the strength of tenant, if the remaining lease term is only 4 years, the investor will be subject to the volitivity of not knowing if the tenant will be renewing the lease or vacating the property. In this scenario, an investor will want to know the “Replaceability” of the rental income. Is the property configured in such a way that a new tenant is likely to be identified quickly? What are the projections for rent rates of a replacement tenant should this come to pass?
What is a Good Cap Rate in Commercial Real Estate?
This question is common among many new investors in commercial real estate. The simple answer is that it depends on the investor. The quality of a cap rate is relative to the investor's requirements, investment strategy, tolerance for risk, and the expected rate of return.
Several trading commercial properties cap rates are in the 4% to 12% range. If you are interested in finding information about the cap rates of Chester County, PA, talk to one of our experienced advisors at Pillar Real Estate Advisors, LLC.
For investors willing to evaluate the future performance of commercial real estate compared to other assets, a cap rate metric is an essential tool. The cap rate valuation method is the beginning in understanding the current value of a property and its potential future performance. However, it is advisable to combine the cap rate valuation method with other valuation methods to know the value and potential of a piece of commercial real estate.
Working with an experienced commercial real estate broker such as Pillar Real Estate Advisors, that understands the real estate business, and how to factor in other market factors, is key to your success in making decisions for your investment in commercial real estate. Contact us today!