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What is a CAP rate and how do you use it in commercial real estate?

Capitalization Rate (CAP Rate) is one of many terms used to determine the value of a commercial property that is leased for profit; it is another way to determine the rate of return.  Cap rates are strongly driven by the income the property is expected to generate but also influenced by the larger area and sub-market where the property is located.

CAP rate = NET Operating Income (NOI) / Current Market Value (expressed as a percentage)

How to practically apply CAP rate to commercial property value?

For the purpose of this discussion, we will discuss how to apply cap rate to purchasing an apartment complex that is 5 units or more.  These formulas can be applied to the six main categories of commercial properties: office, retail, industrial, multi-family apartment communities, land, and miscellaneous.  An example of the different types of commercial properties are: hotels, public houses, sports facilities, medical centers, hospitals, nursing homes, theme parks, self-storage, bowling alleys, marinas, theaters, funeral homes, farms, land used for profit, car washes, industrial properties, retail centers, restaurants, office properties, and gas stations.

CAP rate example:

Property Value = \$2,000,000

Annual rents collected = \$210,000

Annual expenses = \$70,000

Net income = \$140,000

Using the example above, CAP rate = NOI (\$140,000) / Property Value (\$2,000,000) = 7% CAP rate

NET operating income (NOI)

The NOI is all the revenue from the property minus the operating expenses.  Net operating income takes into account the expenses paid to run the property but does NOT include paying the mortgage or debt service.  Expenses, to name a few are: real estate taxes, insurance, contract services, trash removal electric, gas, water, sewer, legal fees, management fees, repairs and maintenance for upkeep, accounting, general/admin costs, payroll, and deposits to replacement reserves.

NOI example:

If a property has gross profit of \$210,000 per year and the expenses are \$70,000, the NET operating income is \$140,000.  To determine your actual cash flow that you keep, you need to subtract the mortgage payment from the NOI.  If the annual debt service in this example is \$80,000, the property owners keep \$60,000 in profit.

How Do I Determine Current Market Value?

The current market value of the property is based on the present-day value of the property as per the prevailing market rates.  Property prices fluctuate widely throughout different sub markets due to supply and demand and the easiest way to determine the going cap rate in a sub market is to ask a commercial lender or commercial mortgage broker.  This is an important point as the cap rate researched online in a particular sub-market may provide a different result than what banks are comfortable lending.  Also, use caution when asking a commercial property broker for the going cap rate as they are incentivized by selling property at higher prices and therefore lower cap rates to put more money into their pockets when they collect commissions.  If a property broker can drive the prices of property up, they can make more money for sellers and can therefore influence lower cap rates in the market.  Just remember that the cap rates that a property broker provides is a “lag” measure meaning that they are using data in the past to influence prices where as a commercial lender will have set their respective cap rate for what they are comfortable lending on in a particular market and although not a “lead” measure, it is more accurate when underwriting a property prior to purchase.

What are typical CAP rates and what they mean?

Nothing is set in stone but cap rates are generally lower in the costal regions because there are sometimes denser populations, fewer apartments being built, and more of a monopoly due to the location.  Moving inland, cap rates tend to be higher meaning that property prices per unit are lower.  Also, it depends on where the property is located in a particular sub-market.  For instance, a buyer may find an apartment building for \$90,000 per unit in Glendale, Arizona, with a 7% cap rate, but that same property in Scottsdale, Arizona, could sell for \$210,000 per unit assuming that the condition of the property and unit composition is relatively the same with a cap rate of 4.5%.  A more expensive property may have a lower cap rate because the value of the property is higher but the amount of rent collected doesn’t offset the acquisition cost and expenses.

Additionally, a higher cap rate of 10-12% could mean that the property is priced so low that the income from rents and fees provides a much higher return.  As a general rule, very high cap rate properties with affordable sales prices may mean that the location of the property will increase the risk of ownership due to the demographics in the area.  An area that is riddled with crime my provide a lot of cash flow but you may have tenants and others burning your dumpsters, breaking windows, and generating a lot more turn-over because the rental collections aren’t as consistent.

Are there differences in lending requirements?

Apartments that are greater than or equal to 5 leasable units require the purchaser to obtain financing that is different than the conventional mortgage that you have on your home with terms of 15 to 30 years; conventional mortgages are used for residential purchases of 4-units or less.  The lending requirements on commercial loans are different than the loan terms you might obtain on conventional mortgage financing for a residential purchase.  Financing can be quite a bit trickier if it is your first time trying to qualify and prove to the bank that you aren’t going to lose the investment property due to poor maintenance, a bad business plan, or a myriad of other factors.

Why discuss boring lending requirements?

Bankers use the data from neighborhoods, comparable sales in recent history, and other trends to determine what the going cap rate should be in the neighborhood.

How can CAP rate lead you to pay too much for a property?

While cap rates can help quickly compare properties with relative value, it should not be used as the sole indicator of an investment’s strength as it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors.  Cap rate ranges do not have a set standard that holds true for an extended period of time in each given market and they are largely dependent on the context of the property and the market.

If a property seller is factoring in potential increased rents that aren’t currently in effect or that haven’t been demonstrated in the local market, the value of the property strictly related to cap rate will move higher.  Unless there is a property very close to the same condition and in the same sub-market, using higher rents that aren’t enforceable to determine the value of the property can lead to paying too much.

Don’t confuse the information above from using pro-forma numbers when investing in a run-down and vacant property.  If you are purchasing a dump that needs a lot of work, you will need to run your numbers on comparable properties in the neighborhood and sub-market.  A solid property manager, real estate agent, or property broker can help you gather information on what properties are renting for in the neighborhood.

What is CAP rate compression?

Cap rate compression is when apartment complexes are rising in price and therefore are selling for more in a given market thereby driving the overall selling cap rate lower.  Using trends to count on an apartment appreciating without doing any work is a form of gambling.  If an apartment is purchased with no intent to improve the operations, increase rents, provide on-going maintenance, complete renovations, or force appreciation through any or all of the previously mentioned plans, there could be financial problems.  If there is a market correction during the ownership of the property, apartment prices may stagnate or drop depending on what happens.  During a market correction or stagnation, tenants may stop paying rent, move-out, lose their jobs, or any combination of unforeseen circumstances.  When this happens, the price of the property will fall thereby driving the cap rate higher.  If your strategy was to purchase a property and sell in less than a 2-year timeline due to appreciation, a higher cap rate and lower property value may completely devastate your plan.

Do not count on cap rate compression saving your investment!

Don’t confuse this term!

CapEx and cap rate are 2 different things.

Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain a property.  An expense is considered a CapEx when it improves the useful life of a property and is capitalized – spreading the cost of the expenditure over the useful life of the asset and can include both interior or exterior renovations.  It is important to purchase a property with enough funds to upgrade or force the value higher through renovations.  Don’t count on the tenants always paying rent as that income may stop and if you haven’t allocated CapEx funds to the project, you will have a disheveled property that doesn’t have anyone paying the rent.