What is a “cap rate” and how does it affect my investing?
A cap rate is simply the annual NOI (net operating income) divided by purchase price, and represents the unlevered annual return on the asset. Because one of the driving factors in investing is income, often times cap rates are “projected” based on an estimate of future income. Capitalization (cap) rates are the most commonly used metric by which a real estate investment is measured. Which begs the question – what is a good cap rate for an investment property? As with any complex topic, the answer is that it depends.
Different cap rates between properties should, in theory, represent different levels of risk and investment. A lower cap rate should correspond to a lower level of risk, while a higher cap rate should imply more risk in the deal. As an investor, the challenge is to determine the appropriate risk-adjusted return, or in other words, the right cap rate given the level of risk on the investment.
Core Factors – what affects cap rates?
When determining the right risk vs cap rate, there are several core factors one can look at, including location, asset type, and the prevailing interest rate environment. Let’s examine each to see how they affect cap rates.
No doubt you’ve heard the phrase, “Location, location, location!”. In real estate, it holds a solid truth. In investment real estate, it becomes even more important. The value of real estate is based largely on demand and location plays a crucial role in that demand. Location can refer to both the Metropolitan Statistical Area (MSA) a property is in (e.g. Seattle vs. New York), and where within that MSA (e.g. urban vs. suburban) it’s located.
MSA is a formal term used to describe a geographical region with a relatively high population density at its core and close economic ties throughout the area. It is often used interchangeably with the term “market”. Each market has it’s own underlying economic fundamentals that should be considered: Primary industry and companies, median household income, average population and education levels. These fundamentals, in each market, have a huge impact on risk and therefore cap rates. Land and existing commercial real estate in close proximity to airports, rail hubs and major cities naturally become attractive investments.
As with nearly everything on earth, commercial real estate investing comes down to supply vs demand. There is only so much raw land available for commercial development in and around key cities within major economic regions. As commercial real estate with attractive cap rates becomes more scarce and major cities are sprawling further into the suburbs, real estate investments will hold intrinsic value within portfolios.
If you are considering investing in commercial real estate or have an established portfolio, call us today. We can run a market analysis to help you position your portfolio in such a way as to ensure to the highest cap rates for long term value.