In real estate, capitalization rates—commonly called cap rates—are useful risk measurements for commercial properties.
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.
Source: CoStar, Q2/2022
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.
Interest rates aren’t the only economic element influencing cap rates. Other factors include:
Looking for more information on cap rates? Our Commercial Term Lending team can draw on its extensive experience and local market knowledge to help you assess the level of risk involved with your current and future investment properties.
JPMorgan Chase Bank, N.A. Member FDIC. Visit jpmorgan.com/cb-disclaimer for disclosures and disclaimers related to this content.