Understanding CAP Rates
Cap rates are always a hot topic amongst commercial real estate investors. You can’t have a conversation with a buyer or seller without talking about what are market cap rates. But in order to understand what market cap rates are, you must first understand how cap rates are calculated.
In their simplest form, cap rates are a mathematical equation that is derived from taking the Net Operating Income (“NOI”) of the property and dividing it by the Sale Price. For example, if a property produces $100,000 in NOI and the sale price is $1,000,000, that would equate to a 10% cap rate. But what exactly does that mean? Some people confuse the cap rate to be the expected return. If you are paying cash for the property, that is true. However, many investors will try to maximize their return by leveraging the property by taking out a loan. In order to calculate your true, cash on cash return, you must subtract the annual debt service from the NOI and then divide by your down payment (or initial cash investment). For example, if your debt service is $60,000 per year and your initial cash investment was $200,000, the formula would be ($100,000 - $60,000) / $200,000 which would equal a 20% return, or twice the cap rate. The relationship between cap rates and interest rates is often overlooked. Since leverage has a direct impact on your cash on cash return, the change in interest rates over time have a direct correlation on market cap rates.
Now that we all know how to calculate a cap rates and cash on cash return, we must understand the factors that influence cap rates. Based off of what we just learned above both market rental rates and interests affect what cap rates investors are willing to pay. However, there are also property specific attributes which influence cap rates. This can be anything from age and condition of the building, to lease length and credit worthiness of the tenants in place. The newer the building, the longer the lease and higher the credit equals the lowest cap rate (resulting in a higher price). Location and market conditions are also a huge indicator of cap rate. Retail properties in high traffic corridors with little to no vacancy can provide the investors with the highest level of confidence and therefore demand the lowest cap rates. Medical properties in immediate proximity to hospital campus would also fit this category. Industrial properties with attributes that are hard to reproduce, such as access to intermodal transportation can also have the same effect. On the other end of the spectrum, suburban office properties, where land is easily attainable and development is active, you will find cap rates that are a little higher.
Properties that often demand the lowest cap rate are new construction retail properties in prime locations with extremely long absolute triple net leases from AAA credit tenants. For example, think of pharmacies, fast food restaurants and automotive related retailers. Often times, these groups will even participate in the development and take a portion of the proceeds in exchange for leasing the property back on a long term basis. Office and Industrial tenants can also participate in sale-leaseback opportunities but the cap rates are usually more middle of the road. The reason is because the properties may not be a prime location, or have the same adaptable or reusable qualities that retail properties often offer. Meaning at the expiration of the leaseback it is way more likely the retail will either renew or be immediately backfilled by a similar user, whereas in an office or industrial building if that tenant doesn’t renew the property could sit vacate for a period of time and take significant tenant improvement dollars.
The last thing to remember when evaluating cap rates, is what your exit cap rate will be at the end of your hold period. We discussed cash on cash return above, which is your year over year return, but your exit price will help determine what your overall internal rate of return will be for the entire hold period. There are certain factors which are beyond your control that will impact the exit cap rate, such as interest rates, future market conditions and lease length you are able to achieve on tenant renewals. The one factor which can offset any potential change in cap rate is if market lease rates increase at a higher rate than any loss in cap rate. If that happens, it’s possible to sell the property for more than you acquired it for merely because of the increase in NOI.
No matter how many investment properties you have purchased it is always important to consult with a commercial real estate agent in whatever market you are considering investing. Cap rates and leasing assumptions can vary from market to market and no one understands market conditions better than a local expert.