Cap Rates 101: Deal or No Deal?

Cap Rates are used to measure the return on investment of a commercial real estate property, which is especially important when a person is considering acquisition. The simple definition of a Cap Rate is the Annual Net Operating Income of a property divided by its Current Market Value; initially a person may assume that an investor would always target higher Cap Rate deals, however, Cap Rates and the properties they represent are complex.

Each asset class of each asset type in each submarket have a typical range of Cap Rates, usually between 4% and 9%. Cap Rates vary drastically due to the risk or stability of a submarket and the property it is evaluating. Assets in desirable submarkets tend to have lower Cap Rates compared to other submarkets within the same asset type. Additionally, newer properties with less expected issues or repairs typically have lower Cap Rates than older buildings. Other important factors for a Cap Rate include the occupancy (stabilized to 90%+), necessity for immediate improvements, term of leases, increases in annual rent within leases, the rent type (Full Service, Modified Gross, NNN, Absolute Net), and the quality of tenants (credit). Credit becomes much more important if the property is a Single Tenant compared to Multiple Tenancy since multiple tenants lower the risk of default by the Sponsor (Buyer). One of the largest factors affecting Cap Rates is the asset type. Asset types from lower to higher Cap Rates tend to be:

Multifamily < Retail < Industrial < Flex < Hospitality < Office

However, this order can vary drastically based on the submarket. For example, a popular travel destination may have a lower hospitality Cap Rate due to more stability in that market compared to others. Also, varying economic factors and trends can affect Cap Rates, so the order may look different in 10 years.

Cap Rates are limited to use for investment properties. Owner-users must look into other metrics for evaluation of a property. Additionally, properties that are value-add such as non-stabilized/high-vacancy properties should use Cap Rates sparingly. A Pro Forma Cap Rate which uses the future potential Annual Net Operating Income of a property may be used in addition to the Current Cap Rate to get a full picture of a property’s potential, but these should be considered carefully and evaluated to the fullest extent.

It is important to remember that Cap Rates are not an all-inclusive metric. This metric does not include any non-operating expenses or mortgage an investor may need for the property. Cap Rates describe the annual return to the investor at an all-cash purchase price similar to alternative investments, such as a one-year bank CD. Today these one-year CDs average low to mid 5%, but unlike the strong guarantee of a lender, real estate carries more risk, pushing investors to pay higher yields. On the other hand, unlike a fixed taxable bank return, real estate carries the advantage of appreciation in inflationary periods and large tax savings by means of depreciation through Cost Segregation; these factors allow real estate to potentially retain a far greater return than an average taxable CD for an investor.