The capitalization rate, or cap rate, is a measure used to estimate and compare the rates of return on multiple commercial or residential real estate properties. In commercial real estate, the cap rate is a formula used to estimate the potential return an investor will make on a property. It is calculated by dividing a propertys net operating income (NOI) by its current market value. The cap rate is expressed as a percentage, usually somewhere between 3% and 20% . A higher cap rate indicates a relatively high income, relative to the property value, and greater risk and return. On the other hand, a lower cap rate indicates lower risk but a longer timeline to recoup an investment.
The cap rate is a useful tool for investors looking to understand how a commercial property might perform relative to other assets. However, it should not be used as the sole indicator of an investments strength because it does not take into account leverage, the time value of money, and future cash flows from property improvements, among other factors.
To calculate the cap rate, divide the propertys net operating income (NOI) by the current market value. The most common way to calculate a commercial real estate cap rate is: NOI/Current Property Value = Capitalization Rate. Cap rates are measured as percentages, typically from 3-20% .
While cap rates are invaluable, they are not the sole metric investors should rely on. Among other limitations, the commercial real estate cap rate doesn’t take mortgage or financing arrangements into consideration. Instead, it assumes a cash purchase.
A "good" cap rate varies from investor to investor and property to property. Some elements that affect a property’s cap rate are hyper-specific. For example, a gas station may have a different cap rate based on which side of the street it’s on—en route to work or on the way home. However, larger forces are usually at play. Cap rate levels are generally a reflection of other larger economic factors.
In general, the following are considered good cap rates for different classes of commercial real estate:
- Class A: 4-8%
- Class B: 6-9%
- Class C: 7-10%
