A capitalization rate, commonly called a cap rate, is one of the most frequently used measurements in commercial real estate. Investors use it to compare income-producing properties and estimate the return a property may generate before financing and income taxes are considered.
Cap rates can be useful, but they should not be evaluated in isolation. Property type, location, tenant quality, lease structure, operating expenses, condition, and market demand can all affect whether a particular cap rate represents a sound investment.
How Is a Cap Rate Calculated?
A cap rate is calculated by dividing a property’s annual net operating income by its purchase price or current market value.
Cap Rate = Net Operating Income ÷ Property Value
For example, consider a commercial property listed for $1,000,000 that produces $70,000 in annual net operating income.
$70,000 ÷ $1,000,000 = 0.07
The property would have a 7% capitalization rate.
What Is Net Operating Income?
Net operating income, or NOI, is the income a property generates after normal operating expenses are deducted.
Operating income may include:
Operating expenses may include:
Mortgage payments, depreciation, income taxes, and most major capital improvements are generally not included when calculating net operating income.
Accurate income and expense information is essential. A cap rate based on incomplete financial records or unrealistic expense estimates can create a misleading picture of a property’s performance.
What Does a Higher Cap Rate Mean?
A higher cap rate may indicate the possibility of a stronger return relative to the property’s purchase price. It may also signal additional risk.
A property may have a higher cap rate because of:
A higher cap rate is not automatically better. Investors should understand why the cap rate is higher and whether the potential return reasonably compensates for the property’s risks.
What Does a Lower Cap Rate Mean?
A lower cap rate often means buyers are willing to pay more for the property’s existing income stream.
Properties with lower cap rates may have characteristics such as:
However, a lower cap rate can also mean there is less room for error if expenses increase or income declines.
Why Do Cap Rates Vary?
Cap rates vary by market, property type, tenant profile, and economic conditions.
An industrial property may trade at a different cap rate than an apartment complex, medical office building, retail center, or general office property. Even two similar buildings can have different cap rates because of lease terms, tenant credit, maintenance needs, zoning, accessibility, or location.
Cap rates can also differ between Eugene, Springfield, and surrounding Lane County communities. Local demand, available inventory, redevelopment potential, and investor confidence all influence property pricing.
For that reason, a cap rate should be compared with recent transactions involving similar properties in the same market whenever possible.
How Buyers and Sellers View Cap Rates
Buyers and sellers often approach cap rates from different perspectives.
A seller generally wants to achieve the highest reasonable sale price. When the net operating income remains the same, a higher sale price produces a lower cap rate.
A buyer generally wants to acquire the property at a price that produces a favorable return. When the net operating income remains the same, a lower purchase price produces a higher cap rate.
This difference is one reason accurate property financials and realistic market comparisons are so important during negotiations.
Is Cap Rate the Same as Cash-on-Cash Return?
No. A cap rate measures a property’s return without considering financing.
Cash-on-cash return measures the annual cash flow an investor receives compared with the amount of cash personally invested in the transaction.
Two buyers could purchase the same property at the same cap rate but have very different cash-on-cash returns because of differences in:
Cap rate is useful for evaluating the property itself. Cash-on-cash return helps evaluate how the investor’s financing structure affects the investment.
Cap Rate Is Only One Part of the Analysis
Cap rate is a useful starting point, but it does not reveal everything an investor needs to know.
Before purchasing an income-producing property, buyers may also need to evaluate:
A property with an attractive cap rate may still be a poor investment if major repairs, vacancies, permitting limitations, or unstable tenants are overlooked.
Evaluating Commercial Property in Eugene and Springfield
Commercial real estate decisions require more than applying a formula to an asking price.
Local property knowledge can help buyers understand how a building’s condition, location, tenant profile, allowed use, and long-term potential affect its value. It can also help sellers determine how investors are likely to evaluate the property’s income and risk.
Eugene Commercial Real Estate assists buyers, sellers, and investors with commercial and industrial property throughout the Eugene-Springfield area. Our approach includes reviewing the property, its financial performance, its intended use, and the practical issues that may affect the transaction.
Contact our team to discuss a commercial property, investment opportunity, or potential sale.
