What Are Capitalization Rates? And Why Do They Matter?

PRI
January 21, 2021

The captialization rate, which is also often referred to as the ‘CAP rate’, is widely used in the commercial property industry. But what exactly is it? How is it calculated? And why is it one of the most important terms you should be familiar with before investing in a commercial real estate development? To find out, keep on reading.

What is the capitalization rate?

This rate is an indication of the rate of return a real estate investment property is projected to give investors on their money. It expresses the net income which a particular commercial property is expected to deliver as a percentage of the property’s market value at any given moment. This gives an estimate of the potential return an investor can expect to get on his or her investment.

It is important to note at this stage that both the potential return and the market value of a property can fluctuate over time. This means the cap rate is not stagnant but can change as the net income or the market value of a property goes up or down.

Example of how the capitalization rate is calculated

Let us look at the case of a commercial real estate property that cost $10 million to construct two years ago. After two years its market value has increased to $11 million. It currently generates a total rental income of  $1,000,000 per year. From that $200,000 has to be deducted for running expenses such as property taxes and maintenance costs, leaving a net operating income of $800,000 per year.

To calculate the capitalization rate is fairly easy. Simply take the net operating income of $800,000 and divide that by the current market value of the property: $800,000/$11,000,000. This gives us a capitalization rate of 7.27 percent.

Why is the capitalization rate so important?

This rate is important for two main reasons:

To compare the return on investment of different properties

If you want to invest $10,000,000 would you rather choose a commercial real estate property with a 5 percent cap rate or one with a 10 percent cape rate? Everything else remaining the same, most people would undoubtedly prefer the one that delivers a return of 10 percent on their money. But there is no such thing as free money, so please continue reading to find out why the 10 percent p.a. investment might not be the right one for you.

An indication of risk

According to Ycharts, the long-term average return on 30-year Treasury bonds is 4.93 percent. This means that in the long run investors could invest their money in an ultra-safe investment and still get a 4.93 percent return p.a. This rate is often regarded as the benchmark for safe investments.

Now if a specific property’s cape rate currently stands at 10 percent per year you should immediately realize that it most likely comes with higher risks than one that only offers 4.93 percent per year. To find out whether this is indeed the case will require further investigation.

It could e.g. be that the property is in such a prime position that tenants are prepared to pay unusually high rentals. In that case, it might be a great investment. It could also be, however, that the property’s market value has been dropping because maintenance has been badly neglected, but that this hasn’t (yet) caused rentals to start dropping. In that case, it’s probably not such a good investment.

Is there a perfect capitalization rate?

Since generally speaking there is a trade-off between risk and ROI (return on investment), there is no one single cap rate that is best for everyone. We can give a few guidelines though:

- PRI recommends that investors should not invest in any commercial property with a CAP rate of less than 6.5%.

- If there are between 1 and 3 years left on the lease term of an investment property, look for a cap rate of no less than 8 percent.

- If there are between 3 and 5 years left on the lease term of an investment property, a minimum CAP rate of between 7% and 8% is recommended.

- For investment properties with between 5 and 10 years left on the lease term, the minimum recommended CAP rate is between 6.5% and 7%.

- In the case of an investment property where the remaining lease term is more than 10 years, look for a CAP rate of at least 6.5%.

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