What is ‘cap rate’ in real estate?
Real estate capitalisation rate, or real estate ‘cap rate’, estimates the potential return that is generated from an investment property. Cap rate assumes that the property is purchased in cash and not debt-financed, indicating the property’s unleveraged return potential.
How to calculate the cap rate of an investment property?
Cap rate, expressed as a percentage, is calculated by dividing the net operating income (NOI) of an investment property by its current market value. NOI is the expected annual income from an investment property less the expenses incurred for managing the property whilst current market value is the present-day value of the property according to the market. This is the most widely used formula for cap rate calculation.
For example, if an investor bought a retail property in the UK with an annual NOI of GBP 500,000 and the current market value of the property is GBP 10 million, the cap rate of the property is 5%. This is derived by dividing the NOI of GBP 500,000 by the current market value of GBP 10 million.
Another way to calculate cap rate is to divide NOI by the purchase price. The purchase price refers to the price that the investment property was purchased at.
Consider if, 10 years ago, the same investor purchased the property for GBP 5 million. Using the second formula, the cap rate of the property is much higher at 10%. This is derived by dividing the NOI of GBP 500,000 by the purchase price of GBP 5 million. The second formula is less commonly used as it presents an unrealistic potential return for properties that were purchased many years ago or when a property was inherited instead of purchased.
Thus, the first formula is a more accurate representation of the potential returns of an investment property.
What do cap rates tell you?
Cap rates are used in various ways when analysing real estate investments. In general, cap rates suggest the time taken for an investor to recover the invested capital and the riskiness of an investment when compared to other investment opportunities.
Cap rates can also be used to compare between similar investment opportunities. For example, an investor can spend GBP 20 million to buy a London apartment building or an apartment building in the outskirts of London. The London apartment building generates GBP 1 million in NOI whilst the apartment building in the outskirts of London generates GBP 1.4 million NOI. The London apartment building is offered at a 5% cap rate whilst the apartment building in the outskirts of London is offered at a 7% cap rate. Purely assessing the cap rate based on numbers, the investor can weigh the risks of buying one asset in a top market and another in the outskirts.
High cap rate versus low cap rate
A higher cap rate implies a shorter time taken for the investor to recover the invested capital and it poses a higher risk as compared to other investment opportunities with lower cap rates.
Do high cap rate properties make better investments?
Higher cap rate properties are not always better investments. The cap rate measures the annual rate of return but does not provide investors with the property’s historical performance. A property with poor historical performance with a high cap rate at the time of purchase may provide a poor estimate of its potential returns.
Does a higher cap rate translate to higher risk?
A higher cap rate usually poses a higher risk as there may be factors that have been overlooked when calculating the cap rate. Cap rates are typically calculated with the assumption that the property generates higher revenue with less operating expenses incurred.
A property with a higher cap rate may require re-modelling and may not be located in a highly desired geographical area which may decrease the actual NOI. The higher cap rate may stem from the lower current market value instead of higher NOI, therefore, posing a higher level of risk.
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What is considered a good cap rate in real estate?
In general, a good cap rate ranges from 8% to 12%. However, there are no clear guidelines on what constitutes a good cap rate as it varies across different types of investment properties, real estate markets, geographic locations, investor risk appetites and different cap rate calculations.
1) Types of investment properties
Risk levels vary across different types of investment properties. For example, residential properties and multifamily homes pose a lower risk compared to office buildings, especially during economic downturns. However, single-family rental homes pose a higher risk than multifamily rental homes as the former has only one income stream. Multifamily rental homes typically have lower cap rates due to lower risks.
2) Real estate markets
As different real estate markets have different economic conditions and risks. a cap rate that may be considered “good” in one market may not be as favourable to investors in another real estate market. For example, a 4% cap rate for a property in New York City may be deemed as “good” and less risky compared to a 4% cap rate for a property in another market like Atlanta, which may not be seen as favourable.
3) Geographic locations
Properties in different locations within the same real estate market have different cap rates and levels of risks. Properties closer to infrastructure, such as highways and public transport, are often priced higher than the rest, thereby decreasing their cap rates.
4) Investor risk appetite
For investors with a conservative risk appetite, the general range of cap rates from 8% to 12% may seem too risky. Conservative investors may prefer investment properties with cap rates as low as 4% to 5%.
5) Cap rate calculations
Not everyone calculates NOI in the same way. Some investors use a 12-month trailing income whilst others make assumptions based on predictions of higher income in the next 12 months. This is referred to as trailing versus forward-looking cap rates. Altering these assumptions can produce radically different cap rate results. For example, when accepting a sub-4% cap rate, the investor is less focused on the trailing cap rate and, instead, is targeting a substantially higher forward-looking cap rate. This investor has likely underwritten the acquisition with an expectation that the NOI can be boosted by raising rents or by leasing out current vacancies. This future improved cap rate is referred to as the “stabilised cap rate”.
Limitations of cap rate
Although the cap rate suggests an estimate of the potential returns an investment property can generate, investors should not solely rely on the cap rate when comparing between investment properties. The cap rate does not take into account other factors that impact an investment such as leverage and future cash flows for value-added properties.
The cap rate formula typically uses expected annual NOI values. This may cause cap rates to be higher or lower than the actual capitalisation rate. Using actual values, where possible, provides a more realistic picture of potential returns.
Frequently asked questions about real estate cap rate
What is a good cap rate for rental property?
A good cap rate for rental property is subjective but it generally hovers around 4%. However, it is still largely dependent on other factors mentioned above. Investors who are interested in stable, passive income would typically go for properties with lower cap rates whilst less risk averse investors may take on properties with higher cap rates and the corresponding risks.
What is a good cap rate for commercial real estate?
A good cap rate for commercial real estate is subjective as commercial real estate spans across three different classes - class A, B, or C.
Class A buildings, also referred to as grade A office buildings, are the most prestigious buildings, with above average rents. They are located in premium locations, with good infrastructure.
Most class B buildings are older and they are located in the suburbs or on the edge of financial districts. They are priced cheaper compared to class A buildings without sacrificing location and accessibility.
Class C buildings offer functional space and basic amenities but pale in comparison in terms of location and infrastructure as its class A or class B counterparts.
Each class has its own range of “good” cap rates but different real estate markets and locations affect what constitutes a “good” cap rate. What then, is a good cap rate for commercial real estate? It is relative to the risk associated with acquiring the asset, the investor’s strategy, risk tolerance, asset class (office, multi-family, industrial, retail) and expected return.
Generally, average cap rates for commercial real estate assets range from -4% for a premium property in a core region to 12% for older properties with slight physical defects, and financial or operational issues.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.