What Makes a Good Cap Rate and How Appraisers Determine Them

In this blog, we will cover:

• How to calculate cap rates using the formula (Cap Rate=NOI ÷Value) and how to adjust the formula depending on the known variables
• Good cap rates
• How appraisers determine cap rates
• Where small balance commercial cap rates are going

Cap rate or capitalization rate is such an important topic in commercial real estate, that we are going to, once again, take time to review. Commercial lenders use cap rates as a quick way to determine if an investment property makes sense. Applying a cap rate to the net operating income (NOI) provides a lender with a quick valuation of cash flowing property and is one of the first back of the napkin hurdles a deal must pass before moving through the underwriting process.

While lenders use cap rate to estimate property values, real estate investors use cap rates to estimate the return on investment for a given cash flowing property. It is calculated by taking the net operating income (NOI) divided by the market value or selling price of a property.

Cap Rate = NOI/Market Value (or Selling Price)

NOI is a measure of a property's gross income minus operating expenses. Operating expenses exclude principal and interest loan payments, depreciation, capital expenditures and income taxes.

Let’s assume a property generates $14,000 in annual NOI and the market value of the property is $200,000. 

Cap Rate= $14,000/$200,000

Cap Rate = 0.07

Cap rates are expressed as a percentage, so in this example the cap rate would be seven percent (7.0%).

Manipulating the cap rate formula to compare investments

For example, let’s say you are looking at two different properties, both generating $20,000 in annual NOI. The first and second properties are selling for a 5.0% and 10% cap rates respectively, so what is the selling price for each?

Using the cap rate formula above and some high school algebra, this is how we determine the selling price for the first property:

5.0% = $20,000/Selling Price

Selling Price= $20,000/5%

Selling Price= $400,000

The selling price for the second property is as follows:

10.0% = $20,000/Selling Price

Selling Price= $20,000/10%

Selling Price= $200,000

Why would two investments with the same NOI differ so drastically in price? While there are several factors for the variation in cap rates, usually the difference can be attributed to the property type, the property condition, or the property location. In the above example, the second property would be deemed a riskier investment, and thus, a buyer would demand a higher cap rate in return for the risk, which the seller is pricing into the deal.

Now what if we want to calculate the NOI and only know the cap rate (5.0%) and selling price ($500,000). Back to using high school algebra, the formula would look as follows:

5.0% = NOI/$500,000

NOI= $500,000 x

Selling Price= $200,000

What is a good cap rate?

We have already established that properties with higher cap rates represent a potential higher return for a real estate investor. So, the answer is it depends on the investor.

A passive real estate investor may want to purchase a property leased to a credit tenant such as McDonalds. These investments are typically based on a triple net lease or “NNN”, which means the tenant, in this case McDonalds, pays for the real estate taxes, property insurance and common area maintenance. This type of investment is considered low risk and low maintenance for an investor, so this type of property may trade in the low 5.0% cap rate range depending on the credit of the tenant and terms of the lease.

Compare this to a small multifamily building where the owner is collecting rents, maintaining the property, paying the real estate taxes along with the property insurance. The cap rate for this type of property will be much higher than the example above because the tenant quality and the hands-on nature of the property. Since the perceived risk compared to the McDonalds property and the amount of work required a real estate investor will demand a higher return on their capital, so you may see these types of property trade closer a 10.0% cap rate.

From the examples, you can see that the investment strategy for an individual real estate investor will be a key factor in determining if a cap rate is good. In the examples above, the real estate investor that purchases the property leased to McDonalds is looking to clip coupons (collect reoccurring income) without much brain damage, while the other investor is looking to make a higher return on their capital and is not afraid of hard work. Generally, the less time and effort an investor has to put into a property, the lower the cap rate or return on their investment.

How are cap rates determined?

Typically, cap rates are determined through looking at comparable properties to determine what the cap rate was, using the formula above, at the time of sale. Then a seller or real estate investor can apply that number to the subject property.

But what if there are no direct comparables in the market? How would you or an appraiser determine the appropriate cap rate for a property?

Well the is a formula that appraisers use to determine an appropriate cap rate for a given property. The formula is as follows:

Ro=(M ×Rm )+((1-M)×Re)

While the formula and calculation are very intimidating to the average real estate investor, conceptually it is determined by looking at the debt and equity components of a particular transaction.
As an example, say a lender is willing to lend at a 40% LTV on a given property versus another property where they may lend at a 70% LTV. Based on this information alone, we know there is going to be a significant impact the cap rate with a change in just this single variable. In this extreme example (assuming all other factor equal), a single change to the LTV there can result in more than a 100-bps swing in the cap rate.

Where are Small Balance Commercial cap rates going?

While the likelihood of an average real estate investor needing to calculate a cap rate based on LTV, mortgage constant and return on equity is zero to none, I wanted to show the formula to provide insight as to where cap rates may be headed in the near term.

In the current low interest rate environment, we can look at the formula and surmise that the single variable most likely to change is the LTV. Commercial real estate lenders do not like uncertainty (i.e. pandemics) and in the face of it the easiest way to mitigate risk is to reduce the LTV on any given loan. The next variable that will most likely be impacted is interest rates, but because interest rates currently remain largely unchanged, the base interest rates that most small balance commercial lenders advertise will most likely remain stable. However, small balance commercial lenders will certainly modify interest rates through “adjustments” to the base rate for factors such as rate structure, prepayment penalty, loan purpose, property type, location, etc.

As we know from the cap rate formula, I would expect to see cap rates increase due to the expected change in these two variables, but by how much remains to be seen. As of this writing, vaccines appear to be on the horizon, which should have a positive impact to cap rates across all property types. As they say on television, stay tuned. Check in regularly to read more about SBC lending, and check out the "Small Balance Commercial" section of our blog.

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