What is a Good Cap Rate in Commercial Real Estate?

What is a Good Cap Rate in Commercial Real Estate?

Learn more about how cap rates are calculated, and what they mean for your broader investment strategy.

What is a Good Cap Rate in Commercial Real Estate?

Learn more about how cap rates are calculated, and what they mean for your broader investment strategy.

As interest rates are rising and more people are starting to worry about the state of the economy, it seems like everyone is talking about cap rate expansion in real estate. But what does that mean exactly, and is this metric really so important in determining an investment’s success?

At the most basic level, a capitalization (cap) rate is a metric that shows the expected rate of return on a specific real estate investment.

Many real estate investors place a huge level of importance on this one metric, because it helps them identify the level of risk associated with an investment, and the amount of time it might take to recover the full investment amount.

But is there such a thing as a “good” cap rate? It depends on what information you’re expecting to learn from this data point.

How Are Cap Rates Calculated?

The formula for calculating cap rates is relatively simple: Subtract the expected annual operating expenses (and taxes) from the property’s expected annual income, and then divide that value by the property’s current value. Multiplying this number by 100 will give you the cap rate.

Say you purchase a property that’s currently valued at $1,000,000. If that property is expected to generate a net operating income of $50,000 per year, its cap rate would be 5%.

At the most basic level, a lower cap rate indicates a lower level of risk, but also smaller returns. A high cap rate indicates a higher risk investment with the potential for larger returns. Cap rates also indicate the expected amount of time it will take to recover the amount you initially invested.

In the example above, a 5% cap rate suggests it would take 20 years to earn back your $1,000,000 investment, because 5% is 1/20.

Does a “Good” Cap Rate Even Exist?

While cap rates can be useful for comparing different investment opportunities and understanding current markets, it’s important to understand that they have their limitations.

In particular, cap rates are an oversimplification, because they don’t take into account factors like leverage, inflation, and the potential for increased cash flow over time.

In general, people tend to agree that a “good” cap rate can be anywhere from 5-10%, but even this should depend on your risk tolerance, the specific asset class, and your ideal time horizon for the investment.

So while cap rates can be useful, they should never be the only metric you should consider. To learn more about seven other data points to pay attention to when investing in commercial real estate, check out this blog post.

Factors Affecting Our Current Cap Rates

While each investment opportunity will have a specific cap rate depending on the value of the property and the amount of income it’s expected to generate, cap rates are partially dependent on a variety of broader market factors. These include the property’s location and the supply and demand for that property type within its market.

Interest rates also tend to impact cap rates, as higher interest rates lead to slowed market growth, and in turn to lower property values. Because of this, cap rates will typically rise when interest rates rise, as we’ve started to see in recent months.

Should You Invest When Cap Rates Are High?

Rising cap rates should not stop you from investing, but they should indicate to you that it’s time to think more critically about which investments are positioned to succeed in the event of a downturn or recession.

If you focus on finding high quality properties located in strong, resilient markets, we believe that you can continue to reap the benefits of commercial real estate investing, even when cap rates are expanding.

This is also a more important time than ever to find partners you can trust to adequately adjust for risk. At Excelsior Capital, our strategy is centered around investing in stable assets in strong secondary markets. We believe these assets can continue to generate strong returns when market conditions are less than optimal.

If you’re interested in learning more about this strategy, and the specific opportunities available to our current investors, please fill out this form to get in touch with our team.

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