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August 22, 2019

Cap Rates Explained

Why Do Cap Rates Matter?

At the Thomas Duke Company, we strive to provide each client with the best information available as we guide a transaction from start to finish. One way we succeed is by sharing the decision-making tools that educated investors need.

In commercial real estate, the capitalization rate (or “cap rate”) is perhaps the single most important ratio to understand. It’s a measure of profitability, and it recognizes an asset’s rate of return as if it were purchased with all cash. Specifically, the cap rate at sale is calculated by dividing the net operating income by the sale price.

Here’s another way to think of cap rate: It’s the percentage of the sale price that will be repaid by rental profits each year. Please note that cap rates do not include the financing costs or debt in any form. The cap rate ratio reflects a universal “apples-to-apples” comparison of an investment’s profitability at the market level.

For instance, suppose two neighboring retail buildings sold this week. Property #1 reports an NOI of $100,000 and a sale price of $1,000,000, for a cap rate of 10.0 percent. Meanwhile, Property #2 reports an NOI of $200,000 and a sale price of $3,000,000, for a cap rate of 6.7 percent. The broker states that, in her analysis, each property sold at market value. Why do similar buildings have different cap rates?

It’s all about risk and return! As overall risk increases, so will the cap rate, meaning a higher annual return on investment. It’s the reward an investor reaps for taking on a property with more risks. We expect that most commercial real estate transactions in Metro Detroit will have a cap rate range above 5 percent and below 12 percent.

Many factors influence a property’s attractiveness compared to other available investments. Location, building condition, neighborhood vacancies, and the quality and term of lease tenants are some factors that greatly affect the investment risk of real estate assets.

In summary, the cap rate formula serves as a first, basic, and important reference point for real estate investors when considering whether a property’s price is reasonable. Ask one of our brokers to help you find cap rates for similar properties to better understand your investment and how it may compare in the market.

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