In real estate, capitalization rates—commonly called cap rates—are useful risk measurements for commercial properties.
The cap rate formula
Annual net operating income (NOI)/the property’s market value
Calculated by dividing a property’s net operating income by its asset value, the cap rate is an assessment of the yield of a property over one year. For example, a property worth $14 million generating $600,000 of NOI would have a cap rate of 4.3%. That means that you can expect a roughly 4.3% annual operating cash flow given the price paid for the property.
What’s a good cap rate? It varies from investor to investor and property to property. In general, the higher the cap rate, the greater the risk and return.
Some elements that affect a property’s cap rate are hyper specific. For example, a gas station may have a different cap rate based on which side of the street it’s on—en route to work or on the way home. But larger forces are usually at play.
“Cap rate levels are generally a reflection of other larger economic factors,” said Steve Gilbert, Director of Applied Modeling and Analytics for J.P. Morgan Investment Banking.
| Metro | Industrial | Apartment | Office | Retail |
|---|---|---|---|---|
| Denver | 5.5% | 4.5% | 5.8% | 5.3% |
| Los Angeles | 4.3% | 3.9% | 5.0% | 5.0% |
| Miami | 5.1% | 5.4% | 5.7% | 5.1% |
| New York | 5.4% | 5.3% | 5.2% | 5.9% |
| Sacramento, Calif. | 5.7% | 4.7% | 6.2% | 5.6% |
| San Francisco | 3.9% | 3.8% | 4.4% | 5.1% |
| Seattle | 4.3% | 4.0% | 5.4% | 5.6% |
| Washington, D.C. | 6.5% | 4.5% | 6.8% | 5.8% |
Source: CoStar, Q2/2022
The impact of interest rates on cap rates
High inflation and the corresponding interest rate hikes can impact commercial real estate cap rates—as interest rates rise, so do cap rates. Cap rates tend to have a narrower range than interest rates, particularly over the short term, Gilbert said. For example, if a building’s cap rate is 4.3%, it may only rise to 4.6%, depending on economic conditions and the property supply and demand balance in a given market.
In recent months, the relationship between interest rates and cap rates hasn’t followed a 1:1 relationship. Rather than mirroring interest rates, cap rates have remained stubborn, especially for multifamily and industrial properties. But according to First American’s 2022 Q1 Potential Capitalization Rate (PCR) Model update, that is changing due to decelerating price growth and continued interest rate increases, both putting upward pressure on cap rates in the second and third quarter of 2022.
“While cap rates and interest rates are loosely correlated, and rapidly rising interest rates would generally imply upward pressure on cap rates, the change in cap rates would typically be mitigated by rent growth prospects, local economic outlook, neighborhood demand/supply balance and other idiosyncratic factors for a specific property or investor,” Gilbert said.
How other macroeconomic factors affect cap rates
Interest rates aren’t the only economic element influencing cap rates. Other factors include:
- Rent growth: Rent growth can accelerate during periods of higher inflation, particularly in apartments with short-term leases. The anticipation of higher rents and greater NOI can offset higher interest rates. Likewise, deteriorating economic conditions can add upward pressure on cap rates and slow rent growth. “Through the second quarter of 2022, apartment and industrial rent growth has been strong, allowing cap rates to remain relatively stable in the face of rising interest rates,” Gilbert said. “More recently, rent growth has slowed. It remains to be seen if the pause is temporary or the start of a reactionary trend to a slowing economy engineered by Fed interest rat
- Gross Domestic Product (GDP) and unemployment: Both GDP and unemployment reflect the health of the economy. When GDP is high and unemployment is low, commercial real estate investments tend to have lower cap rates. When GDP is low and unemployment is high, there’s a greater risk associated with investment properties. But remember: Cap rates are typically forward-looking, and individual deals are affected by a building’s unique prospects and an investor’s viewpoint—as well as the prevailing economic conditions and outlook.
- BBB spreads: “These investment bonds really measure the perception of credit risk of the market,” Gilbert said. “If we think things are overbuilt or there’s going to be a recession in the near future, BBB credit spreads tend to widen, which would drive cap rate spreads higher above the 10-year Treasury rate.”
- Location: Proximity to the city’s employment center, highways and public transit also influences cap rates. Higher demand and stable locations generally have lower cap rates, while transitional or outlying neighborhoods usually have higher cap rates due to higher employment volatility and fluctuating demand. This can lead to higher tenant turnover, leasing costs and other factors that impact operating cash flows.
- Asset class: Cap rates vary across asset classes. Multifamily and industrial buildings usually have the lowest cap rates. The weight of several economic measurements may also vary based on asset class. For example, personal income is a major factor for multifamily and retail properties, and durable and nondurable goods spending is especially important for industrial properties.
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