Intro to CRE: Cap Rates

If you spend any amount of time cruising loopnet looking at commercial properties, you have probably come across a few terms you don’t quite understand. The most common question I get from residential real estate investors wanting to make the jump to commercial assets is “What’s a cap rate?”

In simple terms, a cap rate is the rate of return on an asset purchased with cash. While cap rate isn’t the most important aspect of any property, it can be a key piece of the puzzle, especially when trying to quickly compare properties of the same asset class. The formula to calculate cap rate is the net operating income or NOI, divided by the purchase price.

Cap Rate = Net Operating Income/Purchase Price

Net Operating Income is a beast in it’s own right. It is a number that can be subjective, and something I’ll dive into on it’s own blog, but generally is the gross revenue minus operating expenses, less interest, depreciation, and loan amortization. We’re looking for a cookie cutter number, and since those numbers vary from deal to deal, we don’t include them in this metric.

Purchase Price is simply what you can get property under contract for, not including closing costs, the costs of inspections, repairs, or any other costs associated with the purchase of the asset. That is not to say that those numbers aren’t important. We’ll just use them once we start taking a more detailed look at the property.

In it’s purest form, a cap rate should be an indicator of risk. The higher the cap rate, the higher the risk. Factors that influence market cap rates for asset classes include typical lease duration and terms, quality and quantity of tenants, consumer demand for the for the type of property, and local competition. In an vacuum the “safest” and “nicest” assets in the best locations would have the lowest return. Because things like deferred maintenance, buyer/seller motivation, and localized variables do have their effect, we often see deviation from market rates. As an agent, I see these deviations as the first opportunity to find and add value to a deal.