What is a good cap rate in Commercial Real Estate?

When considering whether to purchase commercial real estate, it is natural for an investor to question whether a specific deal is really a “good deal” or not. And by good deal, they usually mean – will this particular property generate strong returns?

In order to evaluate whether a particular property will be a good investment, it must be compared to other investment opportunities. If someone has $100,000 to invest, for example, they’d want to look at many different investment vehicles (stocks, bonds, commercial real estate, and more) and consider the potential returns of each, and on what time horizon.

Let’s say an investor decides to invest $100,000 in commercial real estate. Maybe they feel this property will have the best return based on the current state of the economy or given the specific market in which they’re looking to invest. Or maybe they want to invest in commercial real estate to diversify their holdings. In either case, the investor now must compare available properties to understand which is the most lucrative investment opportunity.

One of the ways investors compare commercial real estate properties is by looking at the property’s capitalization rate, or “cap rate”. Despite the frequency with which cap rates are referred to in the commercial real estate industry, many people do not understand how they work. It is not uncommon for cap rates to be misused as a blunt instrument to calculate a building’s value without assigning sufficient weight to the nuances of the tenant mix and related leases.

Related:Why Cap Rates are a Blunt Instrument in Office Building Valuation

In this article, we take a look at how to calculate a property’s cap rate, why cap rates are so important when looking to purchase an office building, and some of the key factors that can impact cap rates – as well as uncovering ways seasoned operators uncover hidden value that less experienced investors might miss.

What is a cap rate?

City Center

In commercial real estate, a capitalization rate (“cap rate”) is a formula used to estimate the potential return an investor will make on a property. The cap rate is expressed as a percentage, usually somewhere between 3% and 20%. Cap rates generally have an inverse relationship to the property value. The lower the cap rate, the higher the purchase price and vice versa.

Using a cap rate to value commercial real estate is similar to how investors use multiples when valuing stocks or other equities. The concepts are essentially identical. For example, a 10% cap rate is the same as a 10-multiple. An investor who pays $10 million for a building at a 10% cap rate would expect to generate $1 million of net operating income from that property each year. If that same investor paid $20 million for the same property, but still only earned $1 million in net operating income, we’d refer to this as a 5-cap. This is the same concept as an investor who purchases an entire company for $20 million. If the company earns $1 million in earnings in a given year, this is a 5% yield on the $20 million investment. Stock investors normally refer to this investment as a 20-multiple, but real estate investors referred to this as a 5% cap rate. The formula is one divided by the multiple= the cap rate.

Given the relatively complex, illiquid nature of commercial real estate, valuations can sometimes be hard to calculate – particularly when buying or selling large office properties, as no comparable properties may be available in the local marketplace. Cap rates help provide a comparative tool to look at potential investment properties on a more apples-to-apples basiseven if they are different types of properties or they are located in different market areas.

What is a cap rate for rental properties?

For rental properties, a cap rate represents the yield that property is expected to earn over the next year. It is based on the net operating income and ignores below the line items like debt service. Another way to think about cap rate is as the inverse of a valuation multiple. So for example, if you purchase a property at a 5% cap rate that’s earning $100,000 per year in Net Operating Income, that property would be worth $100,000 divided by 5%, or $2,000,000. Another way to express this is as a 20x multiple, with 20 times $100,000 also equaling $2,000,000.

This exclusion of debt and interest are exactly what makes cap rate measurements so useful. They allow comparisons of rental properties of all kinds based on only the initial investment, not the amount of debt that you would incur to purchase it. While individual financing options may vary, the cap rate will help in predicting potential returns for a rental property based on its own merits.

What is the cap rate for commercial real estate?

Cap rates are only used in commercial real estate. In the most basic sense, a cap rate is a measure of risk. Properties with higher cap rates tend to have more inherent risk, while those with lower cap rates tend to carry lower risks. Property prices are inversely related to cap rates, because higher risk properties tend to have lower prices and vice versa. This is similar to the bond market – the lowest yielding bond is the U.S. Treasury, which is considered to be the safest investment possible.

For all commercial properties, the cap rate is just an initial comparison metric. While it’s helpful for leveling the playing field in the beginning, it doesn’t negate the need for thorough due diligence before an investment decision is made. For more in-depth analysis, the Levered IRR (Internal Rate of Return) is a better metric that includes debt in the calculations.

Cap rates make it possible to get a feel for the risk levels of a particular market and to see how certain properties fit into a particular market landscape. For example, an investor looking for a 100-unit multifamily building will want to compare properties in different parts of the US. Average cap rates for A-class multifamily properties in Chicago may average between 4.5%-4.75%, while those in Manhattan are closer to 3.9%. A building with a 4.6% cap rate would be expected in Chicago, but it’s higher than average in Manhattan, hinting that it may carry a higher risk. Similarly, a multifamily property with a cap rate of 5% would look normal compared to the , but it could be outside the average range for the individual market the property is in.

Cap rates are meant to be viewed in context. They’re a genuinely useful metric for comparing properties across different classes and market areas.

Related: Why Cap Rates Are a Blunt Instrument in Office Building Valuation

How do you calculate cap rates?

How to calculate cap rate for commercial properties

There is a simple formula used to calculate cap rates in commercial real estate. That formula is:

Net Operating Income / Property Value = Cap Rate

The net operating income (NOI) of a property is calculated by subtracting the total operating expenses of a particular property from the total revenue of the property. The definition of NOI is usually the actual NOI from the property over a one-year period. The property value is typically the asking sales price for the property, or the purchase price the investor is expecting to pay for the property.

Debt is not a part of the cap rate calculation, which is why it is so useful to investors. The formula is focused on the property alone, and not the financing used to buy the property. Every investor uses a different combination of down payment and financing, so a cap rate assumes a property is bought for cash without leverage.

How to calculate property value using cap rate

The cap rate formula can be inverted to find out what a property should be valued at based on a specific cap rate. It looks like this:

Net Operating Income (NOI) / Cap Rate = Property Value

To establish market conditions, we will look at recent comparable sales around the area of a target property to find the cap rate data and trends. Incorporating any relevant variables into our underwriting, we will determine a reasonable cap rate based on comparable properties, plus the NOI of a target acquisition to calculate an estimate of the projected value of that property.

Example:

$555,000 (NOI) / 5% (Cap Rate) = $11,000,000 (Property Value)

To get to most accurate value estimate, thorough due diligence and review of all income and expense numbers are required because even slight differences in the NOI can have a disproportionately large impact on the valuation.

This formula is for value estimations only. While we can use it to inform our underwriting processes, it forms only part of the overall valuation process in determining the final purchase price of an investment property.

How to calculate the cap rate on an investment property

NOI is calculated based on the following income information:

Included in operating income:

How to calculate cap rate on rental property

In order to get the cap rate of a rental property, both the NOI and the property value are needed. If the NOI is available but not the property value, there are a few ways to estimate the fair market value of the property by using either the property’s income or comparative data from similar sales in the market.

If there is no way to get a reasonable cap rate based on comparable properties in the market, the Gross Rent Multiplier (GRM) can be used to get an approximate property value. The GRM is a blunt instrument and typically only usually only used in non-institutional assets (unlike those owned here at Feldman Equities). However, it is a metric that is not uncommon in commercial real estate as an initial guide, alongside other metrics, to offer a buyer a general idea of whether an asset is worth further review.

The formula to calculate property value based on the GRM is as follows:

Property Value = Annual income x GRM

Using the GRM means looking at the top line revenues, not the net operating income (NOI). GRM is calculated like this:

GRM = Sale price / annual rental income

It is easier to find gross annual revenue numbers for a rental property rather than exact income and expense numbers. Annual revenue can also be estimated based on the available rental spaces and the average market rates for that type of asset.

If the GRM is available for comparable properties, the average of those can be applied to calculate a target property’s projected value. If there are limited comparable sales, the GRM of the most similar property can be used.

The GRM does not provide with exact numbers. It is an approximation of the value an investor can expect from a property based on past revenues only. Because it does not take expenses into account, it will not give a fully accurate picture of the property value or related risks. However, for a rough estimation to help with direct comparisons of rental properties, it can be useful to benchmark an opportunity.

How does a cap rate work?

Wells Fargo Center

Let’s take an example of how a cap rate is commonly used. Suppose we are researching the recent sale of a Class A office building with a stabilized NOI of $1,000,000 and a sale price of $14,000,000. In the commercial real estate industry, it would be common to say that this property was sold at a 7.14% cap rate.

But what is this cap rate actually telling you?

One way to think about a cap rate is that it represents the percentage return an investor would receive on an all-cash purchase. In the above example, an all-cash investment of $14,000,000 would produce an annual return on investment of 7.14%. Another way to think about the cap rate is that it’s just the inverse of the price/earnings multiple. In other words, as the cap rate goes up, the valuation multiple goes down.

Why is a cap rate important when purchasing an office building?

There are several reasons why it is important to understand that not all cap rates are created equal when buying an office building – and why a cap rate can easily be a misleading indicator of value. When you compare one particular multi-tenanted office building to another, there may be varying levels of such items as: a) overall occupancy, b) the credit worthiness of the tenants c) different lease expiration periods and d) the rents in place may be higher or lower than the market.

Let’s compare two office buildings being sold for $20 million each. Both commercial projects have similar square footage, are located in the same market, and are in similar physical condition. Property A generates $600,000 in NOI vs. Property B which generates $1,400,000 in NOI. Therefore, we would say Property A is being offered at a 3% cap rate vs. Property B at a 7% cap rate.

Both buyers and sellers rely on cap rates to evaluate fair pricing of commercial projects in a given market. In the example above, at first glance, Property B would be indicative of a better deal. However, Property A may only be 30% occupied and if fully leased, it might yield 8.5%. In another example, Property A might be a better deal if all of its leases are very high credit and are extremely below-market.

Cap rates are also used to measure risk associated with a deal. Properties with a higher cap rate generally have more risk than those with lower cap rates. Commercial buildings that require heavy maintenance and have fewer credit-worthy tenants, for instance, may have more risk than a newer, fully stabilized downtown office building. Yet in exchange for that risk, an investor can typically purchase the property at a lower price.

Although cap rates are an important valuation tool, they should never be used as the sole deciding factor when purchasing an office building. In fact, one of the biggest mistakes people make is taking cap rates at face value – which may or may not paint the full picture of an investment opportunity.

One of the reasons for this is that cap rates are generally based on in-place rents – not the market potential. Savvy investors will evaluate deals based on in-place cap rates as well as their potential cap rates if and when rents are raised to market rate.

For example, an office property being offered at a 4% cap rate might actually be a great deal if one of the largest tenants, who’s currently paying below-market rents, has a lease set to expire two years from now. Once this lease expires, if rents can be significantly increased to be brought in line with market rates, then this commercial property might actually be worth much more than it appears to be worth today based on cap rates alone.

What is a good cap rate in real estate?

Cap rates vary widely depending on the asset class being valued and the market conditions where the asset is located. Cap rates usually sit between 3%-10%, but a good cap rate is based more on risk tolerance for a specific investment.

Cap rates can be roughly broken into 3 categories:

Low cap rates: below 5%
Medium cap rates: between 5%-8%
High cap rates: above 8%

These values change depending on the type of property.

Generally speaking, properties with lower risk of loss should have a lower cap rate while those with a higher risk of loss should have a higher cap rate to compensate for the risk the investor is taking on.

This is why the average cap rate for a Class B office building in Manhattan might sit around 5%-5.3% while a Class B office building in Tampa may have a cap rate closer to 6.75%-7.5%.

Class A urban apartments have some of the lowest cap rates across the board, while suburban hotels have some of the highest cap rates on average. To find out if a cap rate is good or not, the asset must be observed in context of its surrounded comparables.

For investors who are looking to make a safer investment, properties with lower cap rates are likely more suitable. Property types with lower average cap rates may fit better into that strategy than those with higher average cap rates.

Investors looking for a bargain price are likely to run into higher cap rates. This is also true for properties that need significant development or renovations. In these situations, higher cap rates between 8%-10% could be considered good.

What is a good cap rate on an investment property?

Because of the subjective nature of cap rates, a good cap rate for an investment property is usually one that doesn’t stray too far from market averages. If the cap rate for a property is significantly higher or lower than those of similar properties, this could be an indication that the property is not valued appropriately.

Investors should be using cap rates as an initial screening tool to see how a property fits into the local market area. This is true for investors looking to evaluate their existing properties as well. If the cap rate of a property is noticeably higher than comparable properties, the property could be undervalued or the income overstated. If cap rates are lower than the comparable market average, the property may be overvalued or the income lower than market averages.

For a savvy investor, an abnormally low cap rate could point towards an opportunity to transform an underperforming property. This is impossible to determine by the cap rate alone. It’s necessary to understand the full picture of what’s happening in the broader market and with that property in particular.

The bottom line is that the cap rate of a building cannot give you a clear picture of whether a property is going to be a good investment or not. But, knowing the cap rate and comparing it with similar properties in the market can lead to deeper investigation into the circ*mstances surrounding a particular property, helping an investor to narrow down the list of choices.

What is a good cap rate on a commercial property?

Depending on which side of the CRE transaction you are on, a good cap rate for a commercial property varies. There is a distinct difference in what an investor looks for in an initial cap rate, exit cap rate, and holding cap rate.

Cap rate compression refers to a situation where cap rates begin to fall as the real estate market grows. This can happen because of the inverse relationship between cap rates and property values. If a market heats up too quickly, sale prices of properties can rise to match demand. This also occurs when the cost of financing goes down, making it possible for buyers to ask for more from sellers. In this circ*mstance, a lower cap rate can be beneficial for a buyer seeking a core plus property or a seller who wants to get out while the market is still hot.

When cap rates are rising, it is referred to as cap rate expansion. This can occur when the cost of financing rises, the market is oversupplied, or if the economic conditions in the market become less stable. Changes to the property itself can also cause the cap rate to increase, including loss of an anchor tenant or damage to the building. All these situations lead to the perception of higher risk for the property, which may be beneficial for buyers with a higher risk tolerance seeking a discounted property.

How does cap rate change between class A, B, and C properties?

First Central Tower

Cap rates will typically vary depending on whether you’re purchasing a Class A, B, or C property.

There is no one specific definition of what classifies a property as Class A, B, or C. But generally speaking, Class A office buildings are considered to be of the highest quality, in the best location, and/or in the newest condition (whether recently built or recently renovated). Class C properties are typically older, in less desirable locations, and may need extensive renovation. Class B properties are somewhere between Class A and C.

There can be different combinations of these scenarios where, for example, a lower quality property may be located in a highly desirable area, or where a property is in new condition but is in a less desirable condition. In any event, the “class” of a property will have some bearing on its cap rate. Typically Class A properties have lower cap rates than Class B or Class C properties.

What is a good cap rate for Class A buildings

Morgan Stanley Tower

Determining a “good” cap rate for Class A office buildings is rather subjective. It depends largely on your local market. For example, a 5% cap rate may be the norm in high-demand areas such as in and around large metropolitan areas and high-cost areas like Manhattan or San Francisco.

The cap rate for Class A office buildings also depends on which asset class you’re considering. Class A office buildings, for instance, often have higher cap rates than Class A multifamily buildings – but again, it depends on the market.

Finally, a “good” cap rate for a Class A office building in a Tier I market (e.g., Boston, San Jose or Washington D.C.) will look different than a “good” cap rate for a Class A office building in a Tier II (e.g., Austin, Philadelphia and Miami) or Tier III market (e.g., Indianapolis and Kansas City). Buildings that are located in Tier I markets tend to have lower cap rates compared to Tier II or Tier III markets.

By way of example: a good cap rate for a Class A office building in each of the three market tiers might look something like this:

Tier I market: 4.00 – 5.25% cap rate
Tier II market: 5.50 – 6.75% cap rate
Tier III market: 7.25 – 8.50% cap rate

However, as stated earlier, an experienced office building operator understands that there is little correlation between the overall cap rate of a building and the actual value of that building. It is a mistake novice investors often make.

In a multi-tenanted building, each lease has to be viewed on its own merit and assigned a specific value that is a measure of the relationship between the creditworthiness of the tenant, and the length of the lease term. Only an aggregation of these disparate metrics can provide insight into the true value of a building and only sophisticated, seasoned operators know how to accurately assess these variances.

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What is a good cap rate for Class B buildings?

All of the points referenced above apply to Class B office buildings, as well. For instance, determining what is a “good” cap rate for Class B buildings will largely depend on the asset class and location of the commercial property.

Cap rates can also vary within the same metro area. For instance, the cap rate for a stabilized Class B office building in downtown Tampa typically ranges from 6.75% to 7.50%. The cap rate for a Class B office building in suburban Tampa is generally a bit higher, ranging from 7.00% to 8.00%.

Keep in mind that a Class A building can very quickly become a Class B building if proper upgrades and improvements are not continually applied. A Class A building, for example, can be relegated to Class B status if a brand-new commercial project with all the bells and whistles – higher ceiling heights, floor to ceiling glass, fitness centers and other amenities, etc. – is constructed in the same sub-market. The local brokerage community will see the new building as superior, assign higher values to the leases which in turn drives cap rates lower, and the previous A-class building, now a B-class building can suddenly find it losing value overnight as it’s cap rate increases and its valuation falls.

What is a good cap rate for Class C buildings?

When evaluating cap rates for Class C buildings, there is generally one additional consideration: most class C office buildings attract a lower credit quality of tenants. For example, an older single-story office building located in the suburbs may be the home to several “mom-and-pop” business. These buildings tend to trade at lower cap rates because it is more expensive to obtain mortgage money from a lender that is skeptical about the creditworthiness of the tenant base.

Class C properties present an opportunity if they are well located. Sometimes this opportunity is referred to as a “value add” acquisition. A value-add commercial property refers to a building that typically has a lower occupancy and is in need of renovation. Value-add properties typically can be purchased at a higher cap rate than stabilized buildings. At Feldman Equities, we have purchased class B and class C properties in great locations; following renovations of these commercial projects, we have succeeded in upgrading the quality of the tenants.

As was the case for Class B properties, a good cap rate for Class C office buildings will be marginally lower for downtown office properties vs. suburban office properties in any given metro area.

Overall, the higher up the Class scale an investor is willing to climb, the lower the cap rates and the higher the pricing. At the very top are Class A, core assets where there is little expectation of capital appreciation and investors are driven by a low risk yield play. At the other end of the spectrum is the value-add Class-C building that will attract tenants with low or no credit, in poor condition requiring continual maintenance, that experience continual turnover of tenants, and that are not well located. Cap rates may be higher in such circ*mstances, but as an owner risk is higher and maintaining income levels requires constant attention.

Related: How Influencer Marketing Saved a 40-property Manhattan Office Skyscraper

What impacts a cap rate?

Castille at Carillon

There are several factors that can impact a cap rate for a commercial project, including the current market condition, current in-place rents vs. market rents, lease lengths and expiration dates, the location of the property, and the condition of the property. We take a look at these five factors in more detail below.

Current Market Condition

The state of the real estate market has a major impact on cap rates. In a tight market, commercial property values tend to increase and therefore, cap rates decline. Conversely, in a down market, prices become more depressed and as a result, cap rates increase. An investor may be willing to buy a property at a lower cap rate in a bull market but will invariably look for higher cap rates in a bear market. Knowing where we are in any given market cycle is critical for investors to understand.

In-Place Rents vs. Market Rents

Cap rates are based upon a property’s existing cash flow. Therefore, if rents are below market rate, an investor has the expectation that his cash flow could jump significantly once the leases in place expire and he’s able to capture the higher market rental rate. In this case, the investor is willing to pay a lower cap rate (i.e. higher price) compared to the same property with in-place leases at market rents.

A savvy operator will look for leases that are significantly below market rate, where they can be gradually increased over a period of time (say, over a one- to five-year holding period) through annual increments to bring them to market levels.

Lease Lengths and Expiration Dates

Lease lengths and expiration dates have a major impact on cap rates.

Lease expirations increase risk, and depending on how great that risk is, can have a depressing effect on the cap rate applied to any individual tenant – meaning it causes the cap rates to rise and the value of that lease to go down with the resulting pro-rata impact on overall building value.

Lease expirations for commercial projects substantially add to risk in a single-tenant situation. Single-tenant properties are like a house of cards – the sheer size of that one tenant can have a huge negative impact on the value of the property if that tenant moves out or goes bankrupt. Leasing to multiple tenants, using staggered lease lengths and expiration dates, is a good way to hedge against this risk. In the event that a building is leased to a single tenant with a very near lease expiration date, the cap rate is often very high.

If a tenant has a very long-term lease at below-market rent, this inhibits an investor’s ability to raise rents and improve the cap rate. For instance, if a tenant has 25 years remaining on their below-market lease, it doesn’t matter than a property has the potential to turn a higher cap rate because you’ll have lost more than two decades of revenue in the process.

Location of the Property

As indicated above, the location of a property has a major bearing on its cap rate. Generally speaking, the better the location, the lower the cap rate and vice versa. This ultimately comes down to perceived risk. Well-located properties tend to hold their value better than those in secondary or tertiary markets, and therefore, investors feel these properties are less risky. Many investors will be willing to take a 5% lower return for a property located in a Tier I market compared to the same type of asset in a Tier II or Tier III market.

Location within the market also influences cap rates. Just as home prices tend to be higher in downtown areas, commercial properties tend to be more expensive in downtown areas compared to suburban or rural areas. Investors are typically willing to pay more for office buildings in central business districts, which translates into lower cap rates.

Condition of the Property

The condition of an asset is the fifth factor to impact cap rates. Properties in better physical condition, particularly those with several in-demand amenities, will usually trade for lower cap rates than properties in need of repair.

As such, one of the first things an investor should do when evaluating whether to purchase an office building, for example, is to look at the bricks and mortar of the structure: if the commercial project has the right bones, if it’s well built and the space lays out well, if there are good views (especially of the water), then a savvy investor will be able to lease the property – regardless of the cap rate. And if you can lease a property, you can drive the cap rates over time.

Conclusion

Park Tower

Cap rates are a highly valuable tool for investors looking to understand how a commercial property might perform relative to other assets. That said, they are often misused as a blunt instrument to calculate building value by inexperienced operators. Looking at individual leases and tenant profiles, though a more laborious process, is far more important in establishing true value and potential of a building.

As noted above, a property’s going-in cap rate might be a victim of below-market rents or poor management. That same property may have the potential to generate much higher returns, and therefore, be worth more under different circ*mstances. An investor should look at both going-in cap rates as well as future cap rates after property improvements are made, as well as the individual characteristics of each tenant, their creditworthiness, the length of their lease and other factors.

Investors should be looking at an investment from all angles, and using the cap rate formula can be a hazardous to your financial health in large scale, multi-tenanted downtown office buildings. Partnering with a seasoned operator who knows what to look for, who is not overwhelmed by headline numbers like the cap rate, and who understands how to uncover value hidden from other is the key to success.

Related: An Introduction to Office Building Investing