5 Factors That Help Determine Cap Rates
Traditionally, the cap rate has been one of the indicators for valuing investment property. Simply stated, the cap rate shows the rate of return an investor receives before debt service. You can calculate it by taking the net operating income of the property and dividing it by the purchase price. The answer will give you the cap rate related to the property.
There are a number of factors that help establish the cap rate of a place. We’ll look at each of these in the following list. Overall, they’ll give you a sense of what’s involved with these figures, which can be helpful as you evaluate properties you’re interested in.
1. The Property Type
Different assets have distinct associated risks with them. For example, multifamily is typically viewed as the most stable investment. If you own a 100-unit apartment building and you lose one tenant, you’ve only lost 1% of your rent role. Given this, investors will generally accept a lower return for these properties. Hence, they will consider a lower cap rate with multifamily investments.
Retail or hotel, and certainly office, might be seen as having higher risks, so investors will usually demand a higher return, and thus a higher cap rate for these assets. For instance, if you only have one retail tenant and they vacate, you might lose all of your rent.
2. Location
Supply and demand drive competition and rates in different areas. Certainly, in prime locations there is more demand, and with more competition, prices will go up. If investors are willing to accept lower returns, they’ll pay more for a property. For secondary and tertiary markets, properties may have to provide a higher return to attract buyers.
3. The Credit of the Tenant
A smaller business, like a mom and pop store, will generally require a higher return than a national credit tenant. That’s because a family-run shop is often considered to have higher risk with it. If the economy takes a downward turn, they could have trouble paying the rent. That said, mom and pop stores often go to great lengths to maintain their place and may be willing to work with an owner to manage fluctuations in the market. Still, investors will look for a higher cap rate with a smaller business.
The larger tenant has the security of a bigger company behind it. For this reason, it’s typically viewed as having lower risk attached to the property. If investors are fairly confident that they’ll receive a stable rent income, they are willing to accept lower returns.
Investors are often willing to accept a lower return on properties that have below market rents if they think that in the near term, they’ll be able to capitalize on higher returns. The lease term plays in to this scenario as well, as longer-term leases usually provide more stability, and investors may accept lower returns for them. Shorter leases that will end soon could bring an opportunity for owners to raise rent rates and make a higher return in the not-so-distant future.
4. The Perceived Upside in Rent
Investors are often willing to accept a lower return on properties that have below market rents if they think that in the near term, they’ll be able to capitalize on higher returns. The lease term plays in to this scenario as well, as longer-term leases usually provide more stability, and investors may accept lower returns for them. Shorter leases that will end soon could bring an opportunity for owners to raise rent rates and make a higher return in the not-so-distant future.
5. Comparable Sales
This is often one of the best ways to gauge cap rates. If you work with a knowledgeable investment sales broker, they’ll be able to tell you how other properties have traded. You can look with them at cap rates for these properties, and then use these as a guide to make your own decision on a property you’re considering.
As you look at cap rates, keep in mind that all these points play a role in the valuation process. You’ll want to look at other factors related to a property before making an investment decision. In the next article, we’ll look at considerations for cap rates in the current market. If you talk to others and have inside knowledge, you could be able to find deals that lead to returns which outperform the market.