Cap Rate vs. Yield in Commercial Real Estate Investing

Cap rate and yield are both important metrics used in commercial real estate investing to assess the potential return on an investment property, but they serve slightly different purposes and provide different insights.

The cap rate, short for capitalization rate, is a fundamental metric that helps investors evaluate the income-generating potential of a property. On the other hand, yield, also referred to as the total return, takes into account not only the property's income but also factors in the potential for property value appreciation over time.

While the cap rate provides a simple and quick way to assess the income-generating potential of a property, yield offers a more comprehensive view by incorporating both income and appreciation potential. Investors should consider both metrics when analyzing commercial real estate investments to make informed decisions and maximize their returns.

What is Cap Rate?

Capitalization rate is a common measurement used to determine a property’s potential for profits. It compares the property’s potential income to its current market value and helps investors get a sense of their rate of return. Cap rate can not only show a property’s potential for returns but can also indicate the riskiness of the investment. If the cap rate is too high, it may mean stronger returns but also more inherent risk.

Cap rate can change as a result of fluctuating property values. It’ll also take into consideration property expenses, such as maintenance and upkeep. Change in upkeep cost will also affect the cap rate because it can impact the property’s overall profits.

Calculating Cap Rate

Cap rate is easy to calculate. It has a simple equation:

Cap Rate = Net Operating Income / Current Property Value

To find a property’s cap rate, you’ll first need to find the property’s expected net operating income. This is the annual income it generates, minus any operating expenses. Things like upkeep, management and property taxes are deducted from net income.

Next, you’ll need to find the current property value. Market prices fluctuate, so it’s important to find up-to-date numbers for a more accurate cap rate.

Finally, you’ll divide the net operating income by the market value, giving you a percentage. Typically, a cap rate between 5%-10% is ideal. A higher cap rate can indicate riskier investment and a lower cap rate can signal that a property is more valuable. So with cap rate, bigger is not always better.

Significance of Cap Rate

Cap rate is a great way to show how profitable a property is and how quickly investors will receive the amount they invested in profits. For example, a property with a cap rate of 10% signals that investors will, ideally, make back their investment after 10 years. Investors may want to compare the cap rates of a few different properties to get a sense of which property would be a better investment. And by looking at properties with strong potential for cash flow and property appreciation, investors may be able to watch their cap rate change over time.

What is Yield?

Yield is another measurement that can help investors determine a property’s potential for success. It shows how much profit a property can produce over the year. While cap rate compares income to property value, yield compares income to total expenses.

Property values won’t affect yield like it does cap rates, only what the investor paid for the property. So yield may not fluctuate with property values; however, it will change as income rises and falls. And if changing property values impact income, then investors may see a change in yield.

Calculating Yield

Yield is expressed as a percentage and shows the income divided by the purchase price.

Yield = Annual Income / Cost of Property

First, you’ll need to determine your property’s annual income, or how much revenue the property makes. Next, you’ll need to identify the purchase price. Then, you’ll divide the annual income by the total costs. The higher the yield, the more money you’ll be able to pocket as profit. A yield between 5%-10% is ideal.

There are also two types of yield investors can look at. Unlevered yield compares the property income to the property cost, whereas levered yield deducts financing costs from the income, which can result in a different yield.

Significance of Yield

Yield is a great way to visualize exactly how much money you’ll make off a property. Plus, it allows you to tally up potential expenses for a property. For a higher yield, you’ll need to find a more affordable property with high cash flow. Comparing the yields of a few different properties can help you find a more profitable investment.

However, it’s important to note that yield is not all-encompassing. For example, yield doesn’t take into consideration property values. Your asset can appreciate or depreciate, and since that doesn’t influence income, it won’t influence yield. The location of your property can also influence yield since property taxes vary from area to area. Understanding things like location and demographics will help you more clearly understand your yield and potential profits.

Comparing Cap Rate vs. Yield

Cap rate and yield are both measures of rate of return. However, cap rate uses the current property value as a denominator, and yield uses the purchase price. Cap rate can show the property's return taking into consideration property appreciation or depreciation. Yield only compares income to the amount paid for the property, not its changing values.

When looking at yield, typically a higher yield is more attractive. However, that’s not the case with the cap rate. Since the denominator is property value, a lower cap rate may show that a property is more valuable, not necessarily that it is less profitable. Looking at the yield and cap rate together can give investors a fuller picture of the property value and its profitability.

Importance for Investors

Making informed investment decisions is crucial, especially in commercial real estate investing. You’ll want to invest in a property that is going to help you grow your portfolio, and selecting the right property will require thorough evaluations of potential for appreciation, cap rate and yield.

Cap rate and yield show very different measurements; however, both are important in guiding investment strategy. Investors might want a higher yield, which will signal overall profitability, and a lower cap rate, which shows higher property value. At the time of purchase, the property value and purchase price may be similar, so investors should look at historical data and expected market trends for that area.

Making Informed Investment Decisions

Cap rate and yield are easily confused, and some people may think they’re interchangeable. But to make informed investment decisions, investors should fully understand both these measurements and what they show. This understanding will empower investors to use them before purchasing or investing in properties, leading to better decisions and hopefully more returns.

Frequently Asked Questions