What is a Cap Rate and Why Should You Care when Purchasing Commercial Real Estate

What is a Capitalization (Cap) Rate? 

The Cap Rate is the rate of return expected, in the current market, when investing in a commercial property and allows an investor to compare the financial risks of one property to another. 

The formula compares the Net Operating Income to the property value. There are various ways to finance property, therefore, the Cap Rate assumes the property is bought in cash and does not factor in a mortgage. 

Why Not Just Compare Properties?

Comparable Properties(Comps) is a common term used in residential real estate. Comps value a property by comparing it to recently sold, similar properties. When people purchase a residential home, they are looking for property that fits their needs (i.e. # of bedrooms, # of bathrooms, updates needed, acreage, etc.). When purchasing property for profit, an investors main concern is typically their profit and loss margins. 

What Cap Rate Should Investors Be Looking for?

Cap Rates vary depending on location, property type, current market, etc. and investors may be willing to accept a lower Cap Rate, if there is less risk, vs. a high Cap Rate, which is more risk. 

For example, in Point Pleasant, NJ, investors usually look for properties with a minimum of a 7% Cap Rate, however, depending on where you are in NYC, a Cap Rate as low as 3% may be acceptable. 

What Affects the Cap Rate?

Type of Property: Multi family properties tend to have lower Cap Rates, than other investments such as industrial, office, or retail. During a recession, or a pandemic, people are still going to need a place to live, so apartments will continue to stay occupied. However, Brick and Mortar stores may not have the financial backing needed to run their business and therefore may be forced to shut their doors, leaving the property owner with a vacant space. 

Location: In a location such as NYC, there is a constant influx of people and tenants needing housing. In growing cities, investing in a property is less risky and therefore, the Cap Rate will likely be lower. In contrast, an investor who purchases property in a less dense area, will probably be looking for a higher Cap Rate, in order to compensate for the risk. 

Use of Property: If an investor is looking for a property in which they intend to occupy, their concerns will shift from focusing on profit and loss, to being concerned with aspects of the building they will need. Investors who are looking to occupy the property are likely to pay a higher price, therefore resulting in a lower Cap Rate. 

How do you calculate the Cap Rate? 

Property Price: $600,000 

Monthly Rental Income: $5,000

Annual Operating Costs: $15,000

Net Operating Income: ($5,000 x 12 months) – $15,000 = $45,000 

CAPITALIZATION RATE: $45,000 / $600,000 = 7.5%