One of the first questions asked in a conversation with the typical experienced real estate investor after the asking price is: What is cap rate and the current yield?
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".
Understanding Cap Rate Fundamentals
What Is a Good Cap Rate on a Rental Property?
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.
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.
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.
How To Calculate Cap Rate
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 to Use Cap Rates
Cap rates are beneficial in several scenarios:
Comparing Properties
Investors can compare cap rates of similar properties in the exact location to assess which offers a better return on investment (ROI).
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.
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.
Key Factors That Influence Cap Rates
Several factors can influence the cap rate of a property:
Location and Property Type
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 Different properties (residential, commercial, and industrial) will have varying cap rates based on demand and rental income stability.
Economic Conditions and Interest Rates
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.
Tenant Quality and Creditworthiness
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.
Lease Length and 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.
Property Condition and Age
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.
What Is Cap Rate Examples by Investment Type
Conservative Investment: Prime Location
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.
Aggressive Investment: Secondary Location
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.
Real-World Calculation Example
Purchase price: $2,000,000 Deposit: $600,000 Loan required: $1,400,000 Interest rate: 6% Annual repayment: $84,000 Cap rate: 5% Net rental return: $100,000 With annual increases of 4%, project returns using the formula for following years.
What Is Cap Rate for Your Investment Strategy
The acceptable cap rate depends on the investor's risk tolerance and investment strategy.
Those prioritising stability and long-term income might favour lower cap rates in prime locations despite lower returns.
Matching Cap Rates to Your Goals
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 Cap Rates Are Less Important
What Is Cap Rate For Owner-Occupied Properties
People buy homes for the lifestyle and pleasure they provide. As such, cap rates are not an important issue.
Development and Redevelopment Sites
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.
Quick Recap: Key Cap Rate Takeaways
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.
Heritage Buildings: Special Cap Rate Considerations
Why Heritage Buildings Have Higher Cap Rates
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.
Expected Cap Rate Premiums
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.
Evaluating Risk Factors in Cap Rate Analysis
Tenant Type and Creditworthiness
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 Factors and Population Trends
Population changes. Is the local population increasing or decreasing? As the population increases, so does the demand for more leasing space.
Industry Demand and Market Supply
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"
When Long Leases Can Be Disadvantageous
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.
Tenant Quality and Business Type
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.
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 Cap Rates Matter for Financing
Cap Rates Loan Approval
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)
Positive vs Negative Gearing Example
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)
Frequently Asked Questions About Cap Rates
What is a cap rate in simple terms?
A cap rate is a ratio of a property's annual net profit income to its market value. It's used to compare investment options and assess potential returns.
How do I calculate cap rate?
Cap rate = Net Operating Income / Market Value
Example: : NOI, $100,000 divided by market value $2,000,000 equals 5%.
What's the difference between cap rate and ROI?
Cap rate measures the property's expected annual return. ROI factors in financing, appreciation, and other investments. ROI is more comprehensive and a better indicator of the actual expected return.
Is a high cap rate better?
Higher cap rates mean greater returns but can signal high risk or lower quality assets. For example owning a property with a high risk tenant with a higher cap rate compared to a lower cap rate for a blue chip national tenant.
Why are commercial property cap rates different from residential?
Commercial property investments use net income (after expenses). Residential often uses gross income (before expenses).
Conclusion: Finding Your Optimal Cap Rate
Aligning Cap Rates With Your 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?
Four strategies to increase property value and attract premium cap rates, see our positioning guide.
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.
About The Author
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.
