What You Should Know About CAP Rates

June 26, 2009 in Seattle Buyer's Guide, Seattle Investor's Guide

One of the primary terms and concepts that will lead you into an understanding of how to structure a sound real estate investment strategy is that of the “Cap Rate.”  After spending many years in the commercial banking industry and making the jump to real estate, it has been interesting to me that many people, including brokers I meet and who have investment properties listed, do not know what a “Cap Rate” is.  First and foremost, it is NOT an indication of or a fixed rate of return., which is what I see it sometimes being used to mean.

“Cap Rate” is short for capitalization rate or a mathematical rate that is assigned to a property based on the risk of the investment.  Simply put, the higher the risk, the higher the rate.  For example,  let’s say you have put money into a 30-year investment which yields 5.6% annually and is federally insured (so there is no risk).  That would be the base rate. Anything higher in risk would have to yield a higher rate, since clearly the question would be why take more risk with your money and not get more in return?(The answer is you wouldn’t!)  Now let’s say a given property has one tenant that pays rent to the owner and has been in the property for many years, has always paid on time and doesn’t wish to move.  Importantly, the income received from the rent is sufficient to pay the mortgage loan and return a substantial amount to the owner.  This is more than likely to have a low cap rate as there is very little risk.  Probably we could guess it would be somewhere in the 5-6.5% rate, as there is always some risk.

Now, if you have a commercial building where there are multiple tenants and you average 10% vacancy and the owner barely can make the mortgage payment based on the rental income, this is a higher risk than the other example and would have significantly higher cap rate, we could say around 8%.  So you can see that what the cap rate attempts to do is adjust the investment property value to what the income can cover.  Using the previously mentioned cap rates and a annual net operating income of $100,000 (a good round figure to make the example easy to visualize), the value of the commercial building would be $1,538,462 using a 6.5% cap rate and $1,250,000 using a 8% cap rate.  That means the higher risk and subsequently higher cap rate would make the property worth $288,462 or 18.75% less, in the eyes of an investor.

Cap rates are one of the basic tools used by appraisers and informed bankers in evaluating the potential value of commercial buildings.  Lenders typically would like higher cap rates as it lessens the value, makes loaning money on the building a better risk and is a more conservative approach.  Conversely, as a savvy commercial property owner, you’d use a low cap rate to increase the value of the building you have for sale.  And yes, over the years, this has been done frequently.  Normally it doesn’t work because the lenders and appraisers come to their independent judgement on what the cap rate should be and adjust it to a realistic market value.  Then what happens is the seller either comes down in price or you have to put down the difference between what the seller wants and the lenders would approve.  In other words, you lose out!

Let the figures inform your decision before you try to assess any more nebulous advantage to the potential investment.  Often real estate investors rely (certainly the sellers would like them to do so) on the impression that there will be future appreciation which will make it worth hanging on by a thread balance sheet wise.  While if you are good with the crystal ball this strategy can work (and has done for many), basically it’s safer to know that the property is a sound investment without the anticipated appreciation at all coming into the analysis.

Remember, investing in commercial property is risky even if you know the potential tenant(s).  You need to evaluate the income and expenses over a multiple years and also look at the tenant leases.  Until then, if you’d like to know if your real estate advisor really knows about commercial properties you might start by finding out if they understand cap rates, I guarantee you the lenders will and who do you think controls the money?  Good hunting.