Cap Rates: What Commercial Real Estate

Investors Need To Know

02 . 11 . 2020

Cap rate is one of the most important and widely used financial metrics in commercial real estate. Unfortunately, it is also one of the most misunderstood concepts as well.

In this article we’ll cover everything commercial real estate investors need to know about cap rates: what they mean, different ways to use the cap rate formula, cap rate spreads, and how cap rates influence the financing of commercial real estate.

What is a cap rate?

Also known as the capitalization rate, cap rates measure the rate of return on an income-producing commercial real estate investment.

The cap rate calculation is a key tool real estate investors use to make an apples-to-apples comparison of similar properties in the same market or submarket. That’s because cap rates can and do vary by property type, sector, and asset class or segment across major markets in the U.S.1

Cap rate formula

In order to determine a property cap rate, investors need to know net operating income (NOI) and the current market value of the property.

  • Cap Rate = NOI / Market Value
  • $500,000 NOI / $8,000,000 Market Value = 0.0625 or 6.25% cap rate

Investors should keep two things in mind when using the cap rate formula.First, NOI doesn’t include debt service or non-cash expenses like depreciation. Second, that market value isn’t always the same thing as market price, because a specific property may be worth more to one investor that another.

Now, let’s look at how the cap rate formula can be used to calculate NOI and market value.

Using the cap rate formula to calculate NOI

When an investor knows the market cap rate and market value for comparable properties, the cap rate formula can be used to calculate what the NOI should be:

  • Cap Rate = NOI / Market Value
  • NOI = Market Value x Cap Rate
  • $8,000,000 Market Value x 6.25% or 0.0625 Cap Rate = $500,000 NOI

Using the cap rate formula to calculate market value

The cap rate formula can also be used to calculate market value using the property’s NOI and market cap rates for similar properties:

  • Cap Rate = NOI / Market Value
  • Market Value = NOI / Cap Rate
  • $500,000 NOI / 6.25% or 0.0625 = $8,000,000

Pros and cons of cap rates

Cap rates play an important part in analyzing the current and projected performance of a commercial property. However, there are also some drawbacks to the cap rate calculation.

Let’s take a look at the pros and cons of cap rates. We’ll start with negatives first:

Cons of cap rates

  • Don’t take into account the power of leverage and financing commercial real estate at today’s low interest rates
  • Only useful for analyzing similar properties in the same market or submarket
  • Can’t be used for investments that do not generate income

Pros of cap rates

  • Provide an apples-to-apples comparison of similar properties in the same market
  • Ignore high LTVs which can be used to artificially boost the return on investment
  • Offer an accurate estimate of real-time value as the real estate market changes

Capitalization rates and the ‘cap rate spread’ between safer investments can also be used to identify potential opportunities in the commercial real estate market place.

What is a cap rate spread?

Cap rate spread is the difference between the cap rate relative to a risk-free investment in 10-Year U.S. Treasury bonds. For example, through Q2 2019 the average cap rate in the U.S. is 5.6% and the 10-year bond pays about 1.6% (as of October 8, 2019), creating a spread of 4%.2,3

The spread between a cap rate and the 10-year Treasury yield can also be thought of as a risk premium. Risk premiums compensate real estate investors for items such as reduced liquidity, and leasing and tenant risk.

Risk premiums or spreads fluctuate depending on the outlook for the commercial real estate market and the income CRE investments generate. If the outlook for income growth is weak, the cap rate spread will rise as risk increases. If there is a positive outlook for income growth, the spread will decrease, causing cap rates to compress.

Of course, it is possible for commercial real estate investors to become overly optimistic. Back in 2006, a couple of years before the Global Financial Crisis of 2008, several Manhattan office buildings sold at cap rates of 4%, 100 basis points below the then current 10-year Treasury bond rate of 5%.4

Are cap rate spreads too high?

On the other hand, a larger than normal spread between cap rates and risk-free investments could be a sign of opportunity for investors. A recent article from the Urban Land Institute (ULI) explains why the current cap rate spread of 4% may be too high.5

Citing data from Real Capital Analytics, the ULI notes that while yields on the 10-year bond have decreased by about 1% over the past year, cap rates across the U.S. have essentially remained unchanged. If interest rates are falling because the economy is weak, then logically cap rates should increase due to a greater perceived risk. But this hasn’t occurred.

ULI notes that if interest rates begin to stabilize and growth expectations remain positive, cap rates should begin to compress. If this happens, cap rate spreads willdecrease and become closer to the global spread levels of about 2% reported by Morgan Stanley.6

How cap rates affect commercial financing

Cap rates measure the worth of a property’s prospective cash flows combined with the level of risk in the real property. For example, two buildings can generate equal NOIs but have significantly different cap rates because one property is considered riskier than the other.

The goal of a lender is to manage risk while collecting interest income and financing fees. That’s why lenders use cap rates to determine the allowable LTV (loan to value) on a loan.

Three main factors that affect commercial financing are:

#1 Owner equity in the property

Also known as “skin in the game”, borrowers with too little of their own capital invested are more likely to default on a loan if the going gets tough. If the LTV of a loan is too high, lenders know that loan risk will rise if the property’s financial performance drops or cap rates in the market significantly increase.

#2 High LTV means less downside protection

If a property purchased at a low cap rate needs to be sold prematurely when market cap rates are high, there may not be enough money from the sale to pay off the loan balance. If this occurs, the loan will default.

#3 Value add may (or may not) boost NOI

Investors buying value add property plan on NOI increasing as the worth of the property increases. Lenders normally provide funding greater than the current market value in the belief that the borrower will create more added value from the lender’s money spent on updating and repositioning. However, if the economy turns down or cap rates rise, the property may end up underwater with gross income barely covering loan payments.

Frequently asked questions about cap rates

Q: What is a good cap rate?

A:Cap rates are influenced by supply and demand and measure the risk and potential profitability of similar properties in the same market area. Factors such as rents, property taxes, and operating expenses vary from market to market. This means that a good cap rate for one market could be a bad cap rate for another, and vice versa.

Q: Is a cap rate the same thing as cash-on-cash return?

A:No, cap rates and cash-on-cash returns measure two different metrics. Cash-on-cash return is calculated by dividing the cash flow that remains after paying all operating expenses and debt service by the amount of cash invested. The NOI part of the cap rate calculation doesn’t include debt servicing expense.

Q: What is the difference between cap rate and ROI?

A:ROI (return on investment) monitors the ongoing performance of an investment. The ROI calculation can be used for both cash flowing properties and those that aren’t generating income, such as rehabs or property being repositioned. ROI also factors in the cost of financing, so the same property can have different ROIs depending on the LTV.

Q: Why is debt service not included in the cap rate formula?

A:Not including debt service in the cap rate formula allows investors to make apples-to-apples comparisons of similar properties in the same market. If loan payments were deducted from the income component of the calculations, the same property could have different cap rates depending on the amount of leverage used by each individual investor.

Important things to remember about capitalization rate

Capitalization rate is the non-financed return on a commercial real estate investment.

Cap rates are derived from transactions between buyers and sellers in specific markets. They can also be used to estimate the future value of a property based on projected income growth or anticipated demand for a specific asset class.

Important things to remember about capitalization rates include:

  • Cap rate is the rate of return on an income-producing property based on the NOI
  • Debt service is not considered when calculating a cap rate
  • Cap rates vary from by property type, sector, and asset class or segment across major markets
  • NOI and market value can also be calculated using the cap rate formula
  • Spread is the difference between a cap rate and the yield on a risk-free investment like the 10-year Treasury bond
  • Lenders consider cap rates when evaluating the level of risk and allowable LTV on a commercial real estate loan

 

References

  1. https://www.cbre.us/research-and-reports/North-America-Cap-Rate-Survey-H1-2019
  2. http://www.ngkf.com/home/research/us-capital-markets-reports/us-capital-market-report.aspx
  3. https://www.marketwatch.com/investing/bond/tmubmusd10y?countrycode=bx
  4. https://www.nreionline.com/finance-amp-investment/cap-rate-spreads-indicator-opportunity
  5. https://urbanland.uli.org/capital-markets/should-cap-rate-spreads-and-cap-rates-be-this-high/
  6. https://www.morganstanley.com/im/publication/insights/investment-insights/ii_2019globalrealestateoutlook.pdf