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What is Cap Rate in Commercial Real Estate?

April 8, 2020 | by Jo Cipolla
Reviewed by real estate expert Jonathan Tootell

The cap rate, which is shorthand for the term “capitalization rate,” is one of those phrases that financial experts often throw around with ease, but remains a mystery to most regular folks without real estate investment experience. However, you’ll discover that it is actually a very easy to understand concept to make sense of once you learn it.

The cap rate is simply a percentage calculated when you divide the annual net operating income (NOI) generated by a rental property by its current market value. It is a ratio used to help commercial real estate investors determine the rate of return that they can expect to get from a rental property.

Calculating the cap rate

To calculate the capitalization rate on a commercial rental property, you need to have two particular figures at hand. The first one is the net operating income, which is the rental income amount minus all operating costs (e.g. maintenance, taxes, insurance, etc). The second figure you need to have is the current market value of the property in question. To discover what is cap rate, divide the first figure by the second.

In short, the cap rate formula is as follows:

Net operating income / market value = capitalization rate

With that simple, straightforward formula, a commercial real estate investor can get a good idea of the rate of return to expect from a rental property.

Breaking down the net operating income (NOI)

To use the capitalization rate formula effectively, you need to make certain both of those critical figures are as accurate as possible. In the case of the net operating income amount, you will actually need to use a separate formula (but don’t worry, it is also very simple!).

In order to determine the net operating income (NOI) amount, you must start with the gross rental income. The gross rental income is the amount of rent paid to the property owner. Needless to say, though, this is not the actual amount that the landlord ends up with when all is said and done, because there are many operating expenses that a property owner must pay to manage the place.

These expenses can include a variety of costs that the property owner is contractually responsible for, including property taxes, maintenance and repairs, insurance, common utilities, and other assorted expenses relevant to the property that the landlord pays for. These various operating expenses need to be added up, and then the total should be subtracted from the gross rental income—and the result you get is the net operating income.

Net operating income (NOI) = Gross Rental Income – expenses (taxes, maintenance, insurance, etc.)

Note: Please be aware that mortgage and interest payments should NOT be included as expenses in the above formula for the net operating income.

Current market value

The other important figure in the cap rate formula is the property’s market value. There are a few different ways that one could determine the current market value of the asset, but typically the most straightforward way to get this number is to simply use the current asking price of the property. Alternatively, you could use the amount that you as a buyer would be willing to offer, especially if you already know you aren’t willing to pay the full asking price.

Original purchase price vs. current asset value

There is some disagreement on whether or not the current market value should be used in the cap rate formula. While it is fairly standard to do so, there are some commercial real estate investors who prefer to use the original purchase price amount in is place. The argument against using the original purchase price, though, is that it could be an outdated number that is no longer meaningful if the property’s value has changed. For that reason, it is usually better to use the current market value of the asset in your capitalization rate formula.

Why is the cap rate an important measure?

So what is cap rate valuable for? Who is using it and what is its purpose?

People investing in commercial real estate are the ones most concerned about capitalization rates. When considering the purchase of a rental property, a smart real estate investor will want to know what the cap rate is in order to assess the risk of the investment. A higher cap rate means that the property in question is a higher risk commercial real estate investment. The lower the cap rate, the lower the risk.

Part of the value of the cap rate as a measuring tool is it allows a real estate investor to evaluate all kinds of different properties—different sizes, asset classes, ages, square footage, etc.—using one common method of comparison.

Why choose real estate investing?

In some people’s minds, “investing” refers mostly to stocks and bonds, or perhaps retirement accounts like 401K and IRAs. But many investors actually focus their investments on—or at least complement their portfolios with—rental properties.

There are different property types that you can invest in, from a small apartment building to a large office park. Whether investing in residential or commercial real estate, an investor can expect a monthly return in the form of a rental income cash flow, which is a very attractive prospect for an investor who appreciates a passive income stream.

Real estate investing can certainly be a good way to make money, and it can prove to be a wise long-term investment—however, investors must be strategic in their choices of properties to purchase. If you just look at the gross rental income, you may initially be impressed with the earning potential. However, it may turn out that the expenses are unusually burdensome, such as high taxes or significant maintenance costs (which is why it’s so important to know the net operating income).

But if a commercial real estate investor can find an investment property with a good cap rate, that means they can expect a worthwhile rate of return on their investment.

What is a good cap rate?

Unfortunately, there is no magic number for what constitutes a good cap rate. In real estate, a lot is relative. (For instance, the seller of a residential property usually determines the current market value of the place, and therefore the asking price, by looking at the selling prices of other similar properties.)

Likewise, a commercial real estate investor may decide whether or not they are satisfied with the capitalization rate on a property based on how it compares to other similar investment properties that they are considering. Does it have a higher cap rate, or a lower cap rate than similar properties? The lower cap rate is lower risk, and may therefore be preferable.

Ultimately it will be important to the real estate investor that they feel they are getting a satisfactory rate of return. Different investors will have different standards for what they view as a good rate of return. What one investor may consider too small a return to go to the trouble of making the investment, another may see as a solid addition to their real estate portfolio.

Putting the cap rate into perspective

Bear in mind that the cap rate is not a perfect measure—or the only measure—of whether or not a commercial real estate prospect is a good one. It is just one tool (and an important one) in an investor’s toolbox for gauging a property’s value as an investment.

When looking at the numbers, some savvy investors may actually come to the conclusion that they could get a better rate of return than what the cap rate currently reflects. For example, looking at the net operating income (NOI) and expenses for the property, the potential buyer may feel that they could end up getting a better rate of return by raising the rent a bit, and by chipping away at some of the expenses (perhaps they have a connection with a maintenance company that charges less than what the current owner is paying).

Where to get this information

If you are wondering where to find information like net operating income and expenses for a commercial rental property, you should be able to find some of it in the real estate listings for the property. If you don’t see the data that you are looking for readily available in the listings, then contact the real estate broker representing the property—that person should be able to supply these vital details for you.

Whether you are a potential real estate buyer or looking to sell a rental property, wrestling with formulas like cap rates (or other insightful figures) can be challenging if you don’t yet have the experience—or the time—to thoroughly understand all of the industry’s financial metrics. Consulting a real estate professional can help you to more easily navigate the process and better understand what cap rate is, how can it be used to make property values comparisons, and what kind of return on investment you might expect.

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