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?

Cap or capitalisation rates are crucial in real estate investment, especially for rental properties. They are often influenced by prevailing bank interest rates, making them a vital consideration for investors seeking optimal returns. Understanding cap rates can be beneficial when interest rates are low, prompting investors to explore various real estate options.

Understanding Cap Rates:

Cap rates provide a snapshot of the expected rate of return on a real estate investment, independent of the property’s financing. This is calculated by dividing the property’s net operating income (NOI) by its current market value. It offers a way to evaluate and compare the profitability of different properties.

For example, if a property has an NOI of $100,000 and is valued at $2,000,000, the cap rate would be 5% ($100,000 / $2,000,000).

When is the Cap Rate Useful?

Cap rates are beneficial in several scenarios:

  1. Comparing Properties: Investors can compare cap rates of similar properties in the exact location to assess which offers a better return on investment (ROI).
  2. Risk Assessment: A higher cap rate often indicates a higher risk, while a lower cap rate usually suggests a lower risk and potentially lower return.
  3. Market Analysis: Cap rates help investors understand the overall market conditions. For instance, lower cap rates in a region might signal a competitive market with high property values and low risk.

Factors Influencing Cap Rates:

Several factors can influence the cap rate of a property:

  1. Location: Properties in prime locations tend to have lower cap rates because they are less risky and often have higher property values. For example, prime City locations vs smaller country locations
  2. Property Type: Different properties (residential, commercial, industrial) will have varying cap rates based on demand and rental income stability.
  3. Economic Conditions: Inflation rates, economic growth, and borrowing costs can all impact cap rates. Higher interest rates push cap rates higher as investors seek better returns to offset borrowing costs.
  4. Tenant Quality: Tenant stability and creditworthiness can affect cap rates. Properties with long-term, reliable tenants often have lower cap rates. For example, supermarkets and other national tenants with long-term leases often have lower cap rates than small independent businesses with shorter leases.
  5. Lease Terms: Long-term leases indicate stability to the commercial property investor. Long-term leases typically have lower cap rates because they reduce vacancy risk and income fluctuation.

Examples of Good Cap Rates:

  • Prime Location with Stable Tenants: A significant city property leased to a government department or a national tenant with a long-term lease might have a cap rate of 3.5%. Despite the lower return, the high security and minimal risk make this a good investment for conservative investors.
  • Secondary Location with Higher Risk: Conversely, a commercial property in a smaller town with a short lease and an average tenant might offer a cap rate of 6%. While this provides a higher return, the increased risk due to potential vacancies and less stable income makes it a more speculative investment.

Choosing the Right Cap Rate:

The acceptable cap rate depends on the investor’s risk tolerance and investment strategy.

  • Conservative Investors: Those prioritising stability and long-term income might favour lower cap rates in prime locations despite lower returns.
  • Aggressive Investors: Those willing to take on more risk for potentially higher returns might prefer properties with higher cap rates, understanding the potential for greater income volatility.

When is a cap rate not so important? 

In some situations, a property may have been recently rezoned to allow for redevelopment into a higher-income-producing property, i.e., it has a higher and better use than it currently has. So, the investor’s prime motivation is to be able to redevelop it as soon as possible.

Conclusion: Cap rates are useful for real estate investors to evaluate and compare rental properties. By considering the location, type of property, tenant quality, and economic conditions, investors can better assess their investments’ potential returns and risks. Understanding cap rates can guide investors in making informed decisions and aligning their investment choices with their financial goals and risk appetite.

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.