Everything You Need to Know About Cap Rate in Commercial Real Estate

The  capitalization rate (cap rate) is used to determine the expected return on investment on a rental property. Cap rate is considered the most important and popular metric for determining a project's profitability and is widely used throughout the real estate industry. Cap rates, a measure of the income produced by a property relative to its investment value, are used by investors to determine whether a property is worthwhile in comparison to other projects. If a property is purchased on cash and not on loan, the cap rate determines the intrinsic and unlevered rate of return. 

Cap rate provides a relative snapshot of a property’s valuation based on the net operating income (NOI) projected for the next year or for the past year. The calculation doesn’t consider future revenue or expense growth, or external factors such as macroeconomic conditions, rent growth, location, or asset class. As a result, the cap rate is just one metric you should consider when determining a property’s value. On the other hand, cap rate levels can also provide insight into larger economic factors, such as competition, monetary policy, and real estate zoning laws and regulations. 

Here you’ll find everything you need to know about cap rate, including the correct formula to use for your calculation to strategies for optimization: 

Understanding Cap Rate

In the simplest terms, a cap rate refers to the annual rate of income an owner can expect to earn on a property. The formula for calculating cap rate is to divide its net operating income by its total cost. Net operating income is determined by determining a project's anticipated yearly revenue and subtracting its operating expenses. Investors can use either an initial capitalization rate or a trailing capitalization rate to help determine a property’s value. The calculations are similar but have small variations: 

Initial Capitalization Rate. The initial cap rate is the most commonly used formula and is found using an NOI with the projected annual revenue of a property. 

Trailing Capitalization Rate. Investors can look into a trailing cap rate, where the formula is found using a property’s past or historical performance over the last 12 months instead of traditional NOI.  

The key difference between the initial and trailing cap rate is in how NOI is used for the calculation; the cap rate looks forward at projected income, while the trailing cap rate looks backward using historical income. 

So, what makes for a good cap rate? It can vary from property to property or based on the investment environment. As a rule, the higher the cap rate the higher the rate of risk and return. As a result, investors typically consider properties with lower cap rates to be less risky but to also require a longer period to recoup returns. Whether or not a cap rate is “good” depends on your firm’s appetite for risk, and this may vary based on broader economic conditions and factors. 

How to Calculate Cap Rate in Commercial Real Estate 

The most common formula used to determine a cap rate is to divide the property’s net operating income (NOI) by the current market value of the property and turn this into a percentage. In mathematical terms, the equation looks like this: 

Capitalization Rate = Net Operating Income / Current Market Value x 100% 

For example, a property costing $11 million that is projected to generate $750,000 in a year would have a cap rate of 6.8%. Investors can then use this metric to determine how long it will take for an asset to begin generating returns. At the 6.8% cap rate, the investor gets a 6.8% rate of annual return. The property will therefore take approximately 14.7 years to pay for itself and start generating positive returns. 

It’s important to note that cap rates are just one metric for evaluating commercial real estate; both macroeconomic and property-specific characteristics should be taken into account when determining a property’s value. 

How External Factors Impact Cap Rate in Commercial Real Estate

External factors can have an effect on the cap rate, and the current economy demonstrates how dramatic that impact can be. High-interest rates instated by the Federal Reserve to quell inflation have introduced uncertainty into the economy. The Fed’s interest rate hikes both increase financing costs and limit transaction volume, which makes it more difficult to assess cap rate. Fluctuations in the interest rate environment and the broader economy can result in cap rate increases.  As a result, cap rates increased by .8% or more between Q2 of 2022 and Q3 of 2022. 

Even though cap rate is a useful metric, it’s important to note the way interest rate, and many other factors can impact cap rate. A few of the other factors that can impact your cap rate include: 

• Location: In general the location of a property can impact the risk on a project. Higher cap rates typically accompany higher-risk locations. 

• Market Size: Properties located in a large, competitive market will have lower cap rates than properties in a smaller market where more risk is involved. 

• Rent Growth: Rent growth accelerates during periods of high inflation, and anticipation of higher rents and higher NOI can offset higher interest rates. In contrast, poor economic conditions can put pressure on cap rates and slow rent growth. 

• Asset Class: Cap rates vary across asset classes depending on fundamentals, supply and demand, and other factors. For example, the ongoing impact of the COVID-19 pandemic and resilience of remote work will continue to impact the profitability of office space assets. The decline of Class B and Class C office space couldn’t have been predicted by cap rate equations, and emphasize the importance of due  diligence in your investment decision-making. 
• Capital Liquidity: The amount of capital you put into a property will have a big impact on cap rate because it impacts your NOI. 

As you look to grow your multifamily portfolio, cap rates are an important metric to keep in mind. However, the calculation is just one metric you should look into as part of your pre-development process, and other calculations such as Internal Rate of Return, Return on Cost, and Yield on Cost may also prove useful. 

Strategies for Optimizing Cap Rate 

In order to optimize your property’s cap rate, you’ll need to either increase the net operating income or decrease the original cost of capital for the property. Here are a few areas you can consider as you work to optimize your project’s cap rate and drive higher returns: 

Expense Management 

The ability to diligently manage expenses helps investors optimize cap rates and drive higher returns. Bringing on experienced property managers can help you streamline operations, keep down costs, and boost the building's overall performance. Proactive and regular maintenance after a property’s stabilization can also help keep up the financial health of a building and ensure the investment is sound long-term. Another way to increase net operating income is to create additional revenue streams; owners have several options in this department, increasing rents to market rates, leasing additional space, or increasing amenities residents are willing to pay for such as vending or laundry machines. 

Tax Efficiency

Be sure to involve tax professionals to help identify opportunities for tax savings, such as property tax appeals, cost studies to accelerate depreciation, and utilizing tax incentives or credits for savings. As capital deployment remains stalled in 2024 due to the interest-rate environment, many firms are rounding out advanced capital stacks with tax-credit programs like the Low-Income Housing Tax Credit (LIHTC) and transit oriented-community incentives.

Leverage Technology to Boost Efficiency 

Modern real estate development software can help your team drive efficiency and bring down costs throughout the development process. Northspyre can automatically capture and organize every project document, extracting data and organizing across budget lines in minutes. The platform makes it easy to manage administrative tasks like data uploads and document management across your portfolio. You’ll be able to automatically generate reports, and stakeholder links, and draw requests simply and effectively. As a result, your team will save time and money. 

Learn More About Northspyre 

Northspyre is a purpose-built, single software solution designed using automation to reduce manual data entry, increase productivity, and maximize your returns from pre-development to project completion. The cloud-based platform enables you and your teams to ensure every aspect of your project is readily at your fingertips for simple and effective project management. Northspyre was created by and for developers and caters to development teams of all shapes and sizes. By decreasing reactive decisions and gaining proactive strategies, your team can increase efficiency by up to 80% and reduce overruns by 66%. 

Download our guide Maximizing Returns: Operating in a New Normal  to learn how your firm can navigate the current economic environment and come out of this period with a competitive edge.