What is cap rate explained?

One of the first questions asked in a conversation with the typical experienced real estate investor after the asking price is: What is the current yield or cap rate?

The cap rate or capitalisation rate is one of the most basic indicators of whether you should continue to consider purchasing a property investment. Cap rates are not always a precise measurement. They are a yardstick to quickly get a general idea of the quality of the investment more importantly, whether you should continue investigating it any further.

Many new investors looking to get into income-producing property are sometimes not sure how cap rates work in negotiating the eventual purchase price. The question is – What is cap rate? More importantly, how is the cap rate determined in assessing the potential return of a commercial real estate investment? Why are property yields higher for commercial than residential investment properties? Generally, property commentators compare investment returns via residential property on gross income. On the other hand, commercial property is usually assessed on net income. Gross return includes all outgoings paid by the landlord, such as maintenance, rates, and other property taxes. We cover this in more detail in our article “Commercial vs Residential Real Estate“.

What is a good cap rate on a rental property?

Generally, cap rates fluctuate with the going bank interest rates. Investors are always looking at getting the best possible returns. This is more common at the moment when interest rates are low, and other options are being looked at. When is a cap rate useful in comparing different real estate rental properties? The cap rate or rate of return tells us what the investment return is on the real estate investment and how it compares to other properties of the same type, size, and location. The cap rate gives us a useful guide and assists us in finding issues that may come up later in our property assessment.

A reasonable cap rate depends on various factors. Factors include location, type of property, redevelopment possibilities, current borrowing rates, inflation rate and other economic conditions. For example, a 3.5% return with a national tenant or government department in a good city location with a long lease can be regarded as good in a stable economic climate. On the other hand, another commercial property showing a % cap rate of 6% on a short lease with an average tenant in a small town can be regarded as poor in an unstable economic environment.

In the above example, the first property with the 3.5% cap rate would be considered a better investment for most conservative investors. It boils down to the risk. If another investor does not see the second property as a risk, they could enjoy a higher return on their investment.

How do commercial heritage building cap rates stack up as commercial property investments?

Cap rates usually vary between heritage and non-heritage buildings with similar positions, quality tenants and commercial leases. The reason is that even though heritage buildings are very attractive to lease, they restrict what modifications are allowed. As such, they are usually more complex and expensive to upgrade and repair.

Redevelopment of the heritage building is highly unlikely. If allowed, many parts of the building would have to be retained, adding to the cost and complexity.

As a result, the cap rates are usually higher for a heritage. So, suppose a modern building was assessed for a cap rate of 4%. In that case, an equivalent heritage building might be expected to be 5-6% plus, depending on the size and appeal of the property.

Several Commercial properties on water edge with different cap rates

What are the risk factors to consider when looking for a reasonable cap rate?

Type of Tenant

Reputable long-tern national blue-chip tenants are traditionally regarded as safe tenants. Real estate investments with these types of tenants usually have a lower cap rate. On the other hand, less familiar and possibly riskier tenants typically have a high cap rate.

Current Economic Factors

Population changes. Is the local population increasing or decreasing? As the population increases, so does the demand for more leasing space.

Demand for that industry or investment type.

Are there any other properties available for lease in that type of industry sector? For example, retail Does it appear that there is enough stock for the current demand? Has the demand for the local vacancy factor demand increased or decreased recently? Is there good evidence that retail rents are growing? Another example could be industrial. In recent years, industrial property has sold for higher cap rates than retail real estate.

Recently, with the growth of online sales, it has also seen an increase in demand for industrial space. Under those conditions, there is a good chance you’ll see lower cap rates because of a shortage of suitable industrial property investments in that particular area. Length of the lease. Most commercial property investors are looking for stability in their investments.

Lenders tend to favour long-term lease contracts as well. Longer, more consistent cash flow makes it is easier to get loans and creates demand and price pressure for that particular property investment. We cover this subject in greater detail in our post “Purchasing Commercial Property Checklist

What are some situations in which the length of a lease could be a disadvantage?

This could be:

If the buyer of the property wants to use the tenancy for their own business.

The buyer is looking at the property as a redevelopment site.

The current rental income paid appears to be well below market.

Quality of the Tenants.

Most property investors tend to shy away from investment property with tenants in declining industries. They are usually regarded as a more riskier investment and will, in most cases, sell for a higher return on their investment. In another example, you may want to compare a typical retail tenant and an office building tenant.

Most of the time, retail businesses are more expensive to set up. In most cases, they require more equipment and fit-out costs. They also must to be more appealing as they are more exposed to the public. On the other hand, a typical office building is usually cheaper to set up and may not require the street appeal of the retail premises. In this particular example, the retail tenant would be more long-term and less likely to move due to these higher initial costs of setup.

Condition and Age of the Property.

Control over operating expenses is critical for any investment. Most property investors understand that the maintenance and the costs of the property should be carefully assessed. With this in mind, better maintained and newer properties generally, sell for lower cap rates. Newer and better-maintained property can also have the advantage of having a higher depreciable value, i.e. a higher level of tax deductions and hidden income.

When are cap rates not very relevant?

The two main situations are

When an investor would like to purchase the property for personal business use, if there is a short lease, they would be able to move in and take over straight away.

When the property is a development site, we often hear of property being sold at very low cap rates. This is misleading because the purchase usually coincides with a rezoning of the area to allow for more lucrative uses and height limits.

In that case, the developer or investor is only concerned about the land value.

Why are cap rates important?

Besides being an indicator of the value of the investment, they can be critical in obtaining and servicing a loan.

Let’s look at the following example of a purchase of a $2,000,000 investment property.

Purchase price: $2,000,000
Less deposit: $ 600,000

Loan amount required: $1,400,000
Interest rate: 6%
Annual repayment: $ 84,000

Cap rate: 5%
Net Rental return: $ 100,000

Annual surplus (year one): $ 16,000 (positive)

In the above example, provided there is a good tenant on a long lease. The borrower has an excellent previous bank record, and they would be highly likely to be able to get a loan because of the $16,000 positive geared situation.

As most leases have annual increases of around 4%, the return will continue to grow.

Returns for following years (annual increases of 4%)

Year 2 $104,000
Year 3 $108,160
Year 4 $112,486
Year 5 $116,985

So at year five, the surplus would be $116,985 less $84,000 = $32,985 (surplus)

What is a good cap rate on a rental property?

In conclusion, cap rates are a quick general method of comparing residential & commercial real estate investments and are treated as such. However, I get asked all the time, “What is a good rate for an investment property?” The short answer depends on the property type and what type of real estate investor they are. With most things in life, the higher the risk, the higher the reward. Also, the lower the risk, the lower the reward, and in property investment, the lower the cap rate. The real estate market changes all time. Market rates fluctuate. In determining what the best property investment type for you is, it is critical to consider your situation.

What are your long-term and short property investment goals?

All investments have some element of risk. What seems like a reasonably good cap rate for a conservative investor may seem inferior to a riskier type. For example, the rental property may have a national tenant on a long lease suitable to a conservative investor. On the other hand, the riskier investor might be willing to accept a new average tenant for a higher rental income with a higher capitalization rate. It may also be a future possibility to add value through rebranding or redevelopment.

Your aim may not be to get the highest return when you buy a property. Instead, it would most likely be the best possible compromise between the rate of return and risk that is most consistent (and gives the best cash flow) for your own set of conditions. Is your real estate investment working for you? Are you getting the best return on your commercial property investment?

Not sure? We are happy to have a free, no-obligation, confidential chat to discuss how we have increased returns for our clients and how it may be possible to get a better return on yours by repositioning your property in the marketplace. Contact Con Tastzidis on 02 9882 2221 at CST Properties for a confidential chat now.

Con Tastzidis - Sydney Commercial Real Estate Agent & Business broker

Written by Con Tastzidis
Con is Managing Director of multi award-winning Commercial Real Estate brokerage and consulting company CST Properties since 2001.
With over 40 years of hands-on experience, Con Tastzidis has etched an indelible mark in the Hotel, Tourism and leisure commercial property and business sectors. Having engaged with national and international hotel and property companies/owners, Con possesses a profound understanding of the intricate dynamics that drive success in this arena.

Con is the author of several books, including Amazon top-selling book “Real Estate Investing For The Residential Investor-The- The 7 Myths of Commercial Real Estate Explained”. In this book, Con outlines many of the successful outcomes he has achieved in both good and adverse economic conditions for his clients. Con has been featured in several national and international media outlets, including FOX, CBS, NBC, ABC, CNN, and BLOOMBERG.
Con can be contacted through this link Feel free to contact Con Tastzidis at CST Properties.