Cap Rates in Commercial Real Estate Explained

If you want to assess the expected return on commercial real estate quickly, consider the capitalization rate or cap rate. The cap rate is calculated by dividing the estimated net operating income by the property asset value. You'll see the cap rate expressed as a percentage.

Investors use the cap rate as a practical tool for quickly comparing the relative value of similar real estate investments in comparable markets. However, it shouldn't be the sole indicator of investment strength. Read on to understand the cap rates in commercial real estate, how to calculate them and their limitations and strengths. 

What Are Cap Rates in Real Estate?

Cap rates in real estate are the ratio of the expected operating income to the total asset value, expressed as a percentage. What are cap rates in commercial real estate? Cap rates are used for assessing investment value in commercial properties. A cap rate of 10% is considered the high end of an ideal investment cap rate range, while a cap rate of 5% is low but still with investment potential. 

While cap rates are helpful for comparing similar properties quickly, the formula doesn't take into account leverage, the time value of money, future cash flows from property improvements or other factors.

Even with those limitations, cap rates remain the most popular option for quickly assessing a real estate investment's potential. The cap rate indicates the property’s intrinsic and unleveraged rate of return. Generally, the higher the cap rate, the greater the risk from the property, but the faster you'll pay off an investment. A cap rate of 10% means you'll pay off the initial investment or recoup the principal in 10 years. 

Cap Rates in Commercial Real Estate: An Overview

Here's what you need to know to calculate the cap rate for understanding cap rates in commercial real estate:

1. Calculating Cap Rates: Formula and Example

The formula to calculate cap rates is simple:  

Capitalization Rate = Net Operating Income / Current Market Value

That means that if the net operating income on a property is $30,000 and its current market value is $500,000, the cap rate is:

$30,000 / $500,000 = 0.06 or 6%

Generally, average cap rates range from 5% to 10%. 

2. Factors Affecting Cap Rates

Cap rates are influenced by various factors that investors should consider when evaluating properties. This includes location, property type, market conditions and tenant stability. For example, tenant stability can affect net operating income. 

While a property might have a net operating income of $50,000 a year if fully booked, if it's typically vacant for half the year, that net operating income estimate drops to $25,000. 

Likewise, for depressed markets or properties in areas appreciating quickly, cap rate might not give you the complete picture.  

3. The Ideal Cap Rate: What to Aim For?

Is there an ideal cap rate that investors should target? That depends on who you ask and what your financial targets are. Different investment strategies and risk tolerances can affect the ideal. 

Different types of properties have different ideal cap rates, as do different areas of the country. For example, Cap rates for multifamily investment properties in major cities range from 3.60% in San Diego to 8.90% in Cleveland. 

Most investors aim for an ideal cap rate between 5% and 10%. According to Statista, cap rates in the US from 2012 to 2022 ranged from about 4% to just over 6%.  A higher number indicates greater risk and a faster investment recovery period. A lower number denotes less risk but an extended investment recovery period. Generally, investors with a greater risk tolerance will look for higher cap rates, while conservative investors favor lower ones. 

Advantages and Limitations of Cap Rates in Commercial Real Estate

Cap rate remains a valuable assessment tool because it works. It offers a clear picture of investment opportunity and balances asset value with expected cash flow. Advantages of using cap rate include:

• Easily compare investment property's earning potential
• Gauge the cash flow and payback period of a commercial property
• Compare similar properties across cities or regions 
• Compare properties for possible investment within a single area

The disadvantages of using a cap rate in commercial real estate come down to what it does include. These limitations include:

• Doesn't work to compare diverse properties and markets accurately
• Doesn't account for leverage 
• Doesn't calculate for interest payments or a mortgage
• Doesn't account for higher returns with renovation

Understanding Risk and Reward: High vs. Low Cap Rate Investments

Any real estate investment carries risks. Some of these risks are expressed in the cap rate. To illustrate the risks and rewards, here is an example of cap rates in commercial real estate:

A commercial property with a market value of $1 million and an expected net operating income of $100,000 would have a cap rate of 10%. With this property, you should recover the full investment in 10 years. 

If the same property has a net operating income of just $25,000, it would have a cap rate of 2.5%. In this case, it will take 40 years to recover the initial investment, but the risk of losing that income is also less. A cap rate this low isn't attractive to most investors since 2.5% is less than you'd earn keeping the money in a high-yield savings account. 

Going back to the 10% cap rate, now suppose the property is an apartment building with 14 apartments. The cap rate of 10% assumes that at any given time, 10 apartments are rented and generate $10,000 annually in income. If new market dynamics like a new apartment building or cost-effective single-family homes become available, it could affect tenant retention and occupancy. You risk that 10% cap rate dropping to 5% or even lower. 

In this example, the higher return is more attractive to investors, but it comes with the risk that market dynamics beyond your control cut into that cap rate and lead to lower returns or losses. On the other hand, a low cap rate is generally a stable investment but waiting 40 years to recover the investment isn't usually the best strategy. 

Strategies to Improve Cap Rates in Commercial Real Estate

With properties under assessment or that you've already purchased, you can improve cap rates to increase resale value and returns. Here are the three main ways to improve cap rates in commercial real estate. 

1. Renovating and Upgrading Properties

Property improvements can positively impact cap rates, attracting higher-quality tenants and increasing rental income. While these changes can be cosmetic renovations, like improved landscaping, a swimming pool or a fresh coat of interior and exterior paint, they can also be major structural renovations. 

Older, dated properties can significantly increase net operating income with renovations. Consider replacing or updating kitchens, bathrooms, windows, doors, locks, flooring and HVAC systems in residential properties. In other commercial properties, look at comparable properties commanding higher rental prices and see what you can adopt. Tactics can include fresh paint, improved lighting, new flooring and higher-end windows or ventilation. 

2.  Effective Property Management

Good property management can lead to higher occupancy rates, longer leases and better cap rates. Since the cap rate is directly related to net operating income, implementing effective property management is the first step to improving cap rates. 

If you've been managing the property yourself, consider hiring a professional management company. Or speak with your property management team about new marketing strategies, property improvements and how to optimize tenant retention. See more on managing rental properties. 

3. Repositioning and Repurposing

Sometimes, repositioning a property or repurposing its use can significantly impact cap rates. For example, a large warehouse space could be repurposed as a luxury retail space or as apartments. While there will be renovation costs, the potential increase in cash flow can improve the cap rate and the repayment period. 

Perhaps the most lucrative way to repurpose or reposition is to purchase homes in areas zoned for commercial use and convert them into retail or office spaces. The reverse is also true: purchasing commercial properties zoned for multi-family or single-family homes and converting the space can prove lucrative for short- or medium-term investments. 

Tips for Interpreting Cap Rates Effectively

If you're unsure whether to take cap rate data seriously in a particular market, consider these tips: 

1. Data Sources and Market Research

Accurate data is crucial for calculating reliable cap rates. Reputable data sources include MLS listings and sites like Zillow and Airbnb. The most reliable data for a property's market value is recent sale data on comparable properties comps in the same market available through the MLS or Zillow data. If there isn't data on local comps, consider comps in similar markets across the country.  

For net operating income, the best data point is actual property data from the previous two years. However, you can also do market research on similar properties in the market to understand their vacancy rates, average nightly or monthly income and net operating income. 

Real estate agents and property managers can offer valuable insights into property value and operating income and expenses in a particular market. 

2. Comparing Cap Rates in Different Markets

Cap rates vary across markets, and comparing them can provide valuable insights. For example, Nashville and Denver both have average cap rates of 5.50% on retail spaces. Other commercial properties between the two cities have similar cap rates. 

If you're considering investing in one of these two cities, looking at cap rates, real estate performance and investment opportunities in the other can give insight into future trends. 

3. Projecting Future Cap Rates

Anticipating future cap rates is essential for long-term investment strategies. Factors to consider when projecting future cap rates include:

• Market saturation by property type
• Whether local demand is increasing or decreasing
• Other developments that can affect growth in the area, such as new office buildings, businesses moving to the area, hospitals, parks or college branch campuses 
• Renovations to an individual property

These factors are all important. For example, if you own an apartment building but a new 100-apartment building is under construction down the street and demand is declining as people move out of the area, the future cap rate of that building might decline. If you own a large commercial retail space in an area where there's a new 100-apartment building going in and several new offices moving to the area, you could see an increase in occupancy and rental prices, leading to a higher cap rate over time. 

Using Cap Rates in Commercial Real Estate

Cap rates in commercial real estate serve as a useful comparison point and a guide. As a real estate investor, you can set cap rate targets based on your risk tolerance and local market norms. To maximize returns, look for properties priced under market value or whose value could increase with simple upgrades. Consider also how to buy your first rental property, REITs vs. rental properties and real estate crowdfunding as alternative or complementary real estate investments.  

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