What is a Good Cap Rate for Commercial Real Estate?

The cap rate is a common method used for valuing real estate properties. Some investors even consider it the gold standard. However, the cap rate is only one part of a larger puzzle for valuing property. 

However, the cap rate can be used to help you quickly compare properties. This article looks at what might be considered a good cap rate.

What is a Cap Rate?

The cap rate is a ratio that allows for a quick valuation comparison between different properties. The cap rate formula is:

 

NOI / Property Value

 

Where NOI is net operating income. The NOI formula is:

 

Gross revenue (i.e., rents)

- Operational expenses

 

The cap rate does not use leverage. In other words, a mortgage is not factored. Cap rate assumes the investor paid cash for a property. A mortgage is not included in NOI because it can vary from investor to investor. This allows for a better comparison between different real estate investments. 

To see how cap rate works, let’s assume a property has gross revenue of $60,000 per year. Expenses are 30% of gross revenue or $18,000. That leaves an NOI of $42,000. The property value is $400,000:

 

$42,000 /  $400,000 = 10.5%

 

Whether 4.5% is a good cap rate or not is something we’ll discuss shortly. But from this calculation, you can see that a lower cap rate equals a lower yield, while a higher cap rate equals a higher yield.

Another way to look at the cap rate is if you buy a $400,000 property with a 10.5% yield, you have $42,000 in net profits per year. That would be the return if you paid cash for the property.

If an investor buys a property with a high cap rate and later sells it at a low cap rate, it can mean a couple of things happened during the holding period. Compared to the 4.% cap rate:

• NOI increased while the property value remained the same (25,000 / 400,000 = 6.25%)
• NOI and the property value both increased, with NOI increasing faster (25,000 / 425,000 = 5.88%)

Of course, an increasing NOI and/or property value are ideal for investors. With an increasing NOI, the investor generates larger cash flows. And a higher property value means appreciation when it comes time to sell.

Some investors look to increase their cap rate by improving the property. For example, an investor makes improvements to their property and can increase gross rent by $5,000. If their original cap rate is 6%:

 

Operational expenses: $5,000 x 30% = $1,500

 

NOI: $5,000 - $1,500 = $3,500

 

Added equity: $3500 / 6% = $58,333

 

In this case, the investor added $58,333 in equity by increasing annuals by $5,000.

Impact of Interest Rates and Cap Rates

Interest rates don't affect NOI since debt service isn't factored in. Interest rates affect borrowing costs, affecting investors' distributions/cash flows.

Generally, cash flow will decrease when interest rates increase, leading to lower IRR (internal rate of return). This reduces offering prices while NOI remains fixed. 

As most investors aren't paying cash for properties, the impact of interest rates on loans is an important consideration when valuing a property. The investor will have decreased cash flow if the loan interest rate is higher than the cap rate. Here's how that works:

 

Property value: $400,000

Loan: $300,000 (75% loan-to-value or LTV)

Cap rate: 4.5%

NOI: $42,000

Interest rate: 5%

 

$300,000 * 5% = $15,000

 

Net profit: $42,000 - $15,000 = $27,000

 

There will be $15,000 less in cash flow per year due to loan servicing costs. 

 

An alternative calculation is:

 

$400,000 x 4.5% = $42,000

$300,000 x 5% = $15,000

Net profits: $27,000

 

As interest rates increase, the investor needs to purchase the property for less if the deal is going to work. Using the above example, let’s say the investor pays $350,000 for the property. Now we have:

 

Property value: $350,000

Loan: $250,000 (70% LTV)

Cap rate: 5.14%

NOI: $42,000

Interest rate: 6%

 

$250,000 x 6% = $15,000

 

For a net profit of $42,000 - $15,000 = $27,000.

 

The more interest being charged, the more return an investor will need. Another way to look at it is the larger the spread between the cap rate and the interest rate, the more money the investor will make (i.e., higher cash flows and ROI).

What is a Good Cap Rate?

Cap rates are generally location dependent. This is a primary theme across real estate investing — location, location, location. An 8% cap rate in NYC doesn’t compare to a 10% cap rate in Boise, ID.

Investors should analyze their local cap rates to get a starting point. Depending on the size and diversity of a city, various neighborhoods may have different cap rates. 

If the cap rate in your target neighborhood is 6% and you find a property with an 8% cap rate, you might be taking on more risk. Many other factors will determine if this is the case. But a quick glance says the target property's cap rate at 8% may be more risky.

If there is potential for lower income growth, an investor will generally want to see a higher cap rate. Here’s why:

 

Years 1-2

Property value: $400,000

NOI: $42,000

Cap rate: 10.5%

 

Years 3-5

NOI: $35,000

Cap rate: 8.75%

 

We know NOI is expected to drop. If the investor can start with a higher cap rate at purchase, they can offset some of the lower NOI when the property is sold:

 

Years 1-2

Property value: $350,000

NOI: $42,000

Cap rate: 12%

 

The idea of negotiating a lower purchase price is that it allows for better property appreciation when it's time to sell the property. This appreciation can potentially offset some or all of the expected decline in NOI. Note that IRR will also be affected.

Multi-family properties often have a lower cap rate because of their stability, which is another way to say these properties have a lower risk. The lower the risk, the lower the cap rate, in this case. Long-term leases generally have lower cap rates, as do low-maintenance properties. 

A lower cap rate isn’t necessarily bad. It depends on what an investor is looking for.

Higher cap rates (compared to surrounding properties) can be found in properties with lower income upside, higher risk, or higher interest rate environments.

 

There are many factors that affect the value of a property. Cap rate is one metric amongst these many factors. But when you need a quick way to compare properties within the same location, cap rate is an effective method.