What Are Capitalization Rates and How Do They Affect Real Estate Prices?
Capitalization rates represent the rate of return on investment (ROI) for a commercial real estate property. The capitalization rate helps buyers, sellers, and investors determine the value of a property and is used to calculate the potential return on investment. Knowing how to calculate capitalization rates and understand the metrics associated with them can help you make informed decisions when investing in or selling commercial real estate.
What Is a Capitalization Rate?
The capitalization rate is calculated by dividing the net operating income (NOI) of a property by its current market value. It represents an investor’s expected rate of return over time, expressed as a percentage. In other words, it gives investors an idea of their potential returns based on the current market value of the property.
For example, if a property has an NOI of $100,000 and a market value of $1 million, then its capitalization rate would be 10%. A higher capitalization rate indicates that the asset is likely to generate higher returns for investors; conversely, lower cap rates indicate that the asset may not be generating high returns for investors.
How Do Cap Rates Affect Real Estate Prices?
Asset types, market conditions, property location and other factors impact the cap rate one may pay. For example, an investment with a strong lease from a national tenant will trade with a lower cap rate because the risk of default on the rents is very low. On the contrary, a real estate investment leased by a weak tenant credit and financials will demand a higher return, or higher cap rate to justify the risk profile. Typically, you will see investments with cap rates ranging between 4 and 8 percent.
In summary, understanding how to calculate capitalization rates and use them to your advantage can help you make smart decisions when investing in or selling commercial real estate properties. By calculating the NOI divided by the current market value you can determine what kind of returns an asset will generate over time—whether those returns will be high or low—and decide whether you want to invest in it or not.
Using a trusted commercial real estate advisor from NAI Excel and NAI Vegas will help you make the best decision to find the right commercial real estate investment.