What is a good cap rate in Commercial Real Estate?
Commercial Real Estate refers to real estate that is leased out to one or more tenants. It refers to the business of owning and leasing real estate, which may consist of office buildings, shopping centers, industrial buildings, etc.
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 had $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 return potential 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 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.
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?
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 basis.
How do you calculate cap rates?
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 does a cap rate work?
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.
How does cap rate change between class A, B, and C properties?
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
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.
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.
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 circumstances, but as an owner risk is higher and maintaining income levels requires constant attention.
What impacts a cap rate?
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.
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 circumstances. 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.