Understanding Cap Rates in Commercial Real Estate
An experienced residential real estate investor called me the other day. He was a bit new to commercial real estate and he had a question:
“I thought I heard you say that a lower cap rate means a higher price. Did I hear you right? What do you mean?”
Fifteen minutes later we hung up and he sounded satisfied with my answer. I remembered that I had a similar question about a decade ago as I made the transition from residential to commercial real estate myself. I thought I would take a moment to explain how this works and why it matters so much. Mastering this number could be a critical step in you making a good acquisition/investment. Failure here could result in a disaster for you and your investors.
What is a cap rate? How is it calculated? How does cap rate reflect risk? Why should I care? How do I use it? Can you provide an example? What is the airspeed velocity of an unladen European swallow?
These are all questions I’m hoping to answer in this post.
The Definition and Calculation of Cap Rate
Cap rate is short for “capitalization rate.” The capitalization rate is the rate of return that an investor would generally expect for a certain type of unleveraged asset, in a specific location, at a given point in time. I say “unleveraged” because we don’t factor in the debt for this calculation, and we don’t subtract the debt service (loan principal and interest) on the all-important “value formula” that uses the cap rate.
How is it calculated?
On an existing asset with an existing income stream, the cap rate is calculated by dividing the annual net operating income (NOI) by the value of the asset. If you are selling or buying this asset, this value could be the sales price.
If you are projecting the cap rate, say on a future purchase or the development of a new property, the calculation is similar. It is the projected NOI divided by the sales price or construction cost.
In either case, the debt service is not factored into the equation.
If someone is selling you a mobile home park for $1 million, and the NOI is $70,000 annually, calculate cap rate as follows:
Cap Rate = NOI ÷ Value.
Cap Rate = $70,000 ÷ $1,000,000 = 7%.
Why should I care about cap rate?
It is helpful to have a metric to go by to compare different assets. And to know what type of return you can expect. When you first talk with commercial brokers and lenders, they will be listening to see if you are a newbie or if you have experience. Using industry terms like “cap rate” and “NOI” are important.
When someone calls me and says, “I have a chance to buy an apartment building in my town for $55,000 per unit. Is that a good deal?”, I typically think it’s probably someone on the new side. If they say, “The trailing cap rate is 7%, and I believe it has value-add opportunities that would allow us to operate at 9%,” then I might think they have more experience.
In the example above, is $1 million for that mobile home park too high, just right, or a bargain? Well it depends.
If you are looking for a 10% ROI, again not including debt service, then this asset is over-priced. You would not want to pay more than $700,000 ($70,000 ÷ $700,000 = 10% cap rate).
If you are comparing it to an apartment complex at a 5% cap rate, then perhaps this is a bargain. Or is it? It is crucial to factor in a lot of other factors. Factors like potential value-adds, the hassle of managing this asset, your experience in this asset class, the type and cost of debt, investor expectations, and more. It often comes down to risk.
How Does Risk Impact Cap Rate Calculations?
The cap rate is a measure of return on investment (ROI). But if you think about it, the desired ROI is a reflection of risk tolerance. Ask yourself this pair of questions:
Is a 2% ROI (cap rate) a bad deal?
Is a 20% ROI a great deal?
The answer should be... well, it depends.
Huh??
T-bills, US bonds, and other treasury debts, which are considered practically risk-free, have interest rates lower than this. In answer to my question, you might have thought, “Only an idiot would buy something at a 2% cap rate.” Yet these assets are purchased by the billions, by really smart people and institutions, daily. And in countries where interest rates have gone negative, some people are willing to actually tolerate a negative ROI to hold certain assets.
So certainly you should jump at a 20% cap rate, right? After all, mobile home parks are among the safest asset classes on the planet, and they used to trade at a 10% cap rate. Now they’re hard to find at a 7-cap (7% cap rate). So anyone would love to get triple the going return in a 2-cap deal, right?
Not so fast.
If there was a deal like this, there would certainly be a good reason for it, don’t you think? It cap rate reflects risk, then this is likely a very risky deal.
For example, if someone offered you an opportunity to invest in a 20-cap deal that had a 10% chance of earning 20%, and a 90% chance of going bust, would you do that deal? Of course you wouldn’t. The risk is simply too high.
But what if you were told that the deal had a 90% chance of doubling in value, and a 10% chance of going bust. Would you invest in that deal at a 20% cap rate? You might.
This is a simplified example of how understanding and comparing cap rates is valuable. It allows you to compare deals across different asset classes and allows you to think hard about risks and return.
How do I find out what the cap rate should be…for my market and asset?
This is both an art and a science. It takes knowledge of the asset type and class... the local mark... the national market... and the economy. It may involve published statistics... and counsel from local commercial brokers, lenders, and appraisers.
Integra Realty Resources (IRR.com) publishes estimated cap rates for major markets around the nation. Even if you’re in a smaller market, it can be helpful to review their lists to learn more about cap rate calculations.
Integra states that the cap rate is driven by these seven factors:
Supply and Demand
Property income growth
Local economy, Job Growth, Unemployment
National Economic Conditions/GDP Growth
Interest Rates
Availability of Financing
Risk Premium of Private Real Estate
Examples of Cap Rate Calculations
I’m getting into dangerous territory here because I must over-generalize here, and I’m opening myself up to arguments. But that’s ok. Hopefully this will be helpful to some. Please note that these examples are hypothetical for the purposes of illustrating potential cap rates.
A 150-unit Kansas City Class A Multifamily
I chose KC for our first three examples because it is a mid-sized city in the heartland. Class A could refer to a fairly new asset (new or up to perhaps a decade old). This one is an urban location with public transportation available. I would guess the cap rate on this would be about 5% to 5.75%. The fact that it has little or no deferred maintenance, predictably low repairs needed, and would have favorable demand since new would impact my thinking.
A 150-unit Suburban Kansas City Class B Multifamily
This asset could be about 15 to 40 years old. It has already gone through one or two upgrades. It has some design elements that are outdated, and the HVACs and roofs will need to be upgraded soon. It is in a middle-class suburban location. I would guess this cap rate on this would be in the range of 5.75% to 6.75% right now. A buyer may get some upside through value-add upgrades to the units.
A 150-unit Suburban Kansas City Class C Multifamily
This asset is perhaps 40 to 70 years old. It is in a rough part of town, but not a war zone. It has outdated design features like small bedrooms and closets, and tiny kitchens. The demographic in this part of town cannot afford higher rent, so the buyer of this asset does not plan any significant value-add upgrades. Their profit will come from a reliable income stream from a working-class tenant base plus filling vacant units and improving the delinquency caused by poor management by the current owner. I would guess the cap rate at about 7% to 7.5%.
A 150-unit Brooklyn NY Class B Multifamily
This asset was built in the early 80s. It has some value-add opportunities available. Rents are high and stable. A bidding war for this asset may ensue, which could compress the cap rate. Institutional buyers and high net worth cash buyers with an appetite for this location will be in the mix. Profits will be derived from cash flow and some value-adds. I would guess the cap rate here at 3.75% to 4.25%.
A Baytown, TX Mobile Home Park
Mobile home parks do not require the same demographics as multifamily and some other asset classes. A 90% occupied park in a town of 75,000 or so can perform very well. Mobile home parks often have some upgrade opportunities, and steady, predictable income. This park has about 175 spaces, so it could be of interest to an institutional investor if acquired and upgraded. This could be profitable. While mobile home parks could routinely be acquired at about a 10% cap rate for decades, recent interest in this asset class has driven cap rates down. I would guess this asset could be acquired for a cap rate between 6.5% and 8%.
A Roanoke, VA Self-Storage Facility
Like mobile home parks, self-storage does not require a large population base to be successful. It is micro-local and I know of a very successful facility in a Texas town of 15,000 or so. Roanoke is a middle-of-the-road city that was relatively stable through the last recession. This facility is in a slightly under-served part of town with very few opportunities for new competitors to spring up nearby. It has some land to add units, and parking area out front to add U-Haul. I would guess this cap rate in the 6.5% to 7.5% range.
A Triple-Net Leased Google Data Center
This arrangement allows the building owner to pass back repairs, insurance, utilities, taxes, etc. to the tenant. This is a very low risk venture for the owner. And it’s made even lower by the Class A+ tenant with a 20-year lease. Recall that low risk (greater certainty) leads to a lower cap rate. I would guess this one at 3.5% to 4%.
A 15-unit Class B Multifamily in Martinsville, VA
The risk on this asset is increased by the small size of both the asset and the city. The unemployment rate in this town rose to above 20% when the textile mills pulled out a few decades ago. An asset of this size in this location will not be of interest to as many buyers, which helps you on the buy-side, but hurts you when you go to sell. I would put this in the range of 8% to 9%+ cap rate.
A Brand-New 650-unit Self-Storage Facility in Dallas
Some merchant builders got to the trouble (and significant risk) to acquire land, get permits, do architectural/design, and build facilities just to sell. They put them on the market to sell upon certificate of occupancy, or sometimes they operate them for a year or two first. This is sort of a trick question because there may not be any trailing income. Since the formula is Value = Income ÷ Cap Rate, the answer would be zero in that case. So this is a time when the seller may want to negotiate a price based on the cost plus profit. And the buyer may do calculations based on the potential value formula, which is based on the potential income. If the facility is well-located and set up for an institutional buyer, I can see this buyer (often a REIT) making their projections based on a 5% to 5.5% cap rate.
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Real estate investments and securities offerings are speculative and involve substantial risks. Please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.