Cap Rates in San Francisco, California

Second Quarter 2024 Multifamily Cap Rate Report

Multifamily Cap Rates Predicted to Remain Flat

Updated September 18, 2024

Multifamily

According to Moody Analytics, Multifamily Rent Growth was up slightly from 2.6% in Q1 2024 to 3% in Q2 2024, and vacancy rates held steady at 5.7% through mid-2024.  These metrics along with the lowering of multifamily interest rates have allowed supply and demand for apartment buildings to slightly improve during the second quarter. However, according to CBRE, multifamily cap rates over all stayed flat on A Class properties during this time period at 5.07% and 5.14% on B Class Properties. C Class properties had some cap rate expansion from 5.64% during the first quarter to 5.76% in the second quarter. This is most likely due to operating expenses increasing on insurance, taxes and maintenance, keeping net operating income from increasing.

Industrial

Industrial properties have had a huge upswing in performance over the last three years due to the end of supply chain problems causing a record number of new industrial developments. This trend slowed significantly during 2023 due to a record number of new industrial developments coming on line in 2024. According to CBRE, it has been this over supply of new industrial properties in 2024, that has kept net absorption rates low causing a 30 basis point increase in the overall vacancy rate, rising it to 5.6% during the second quarter of 2024. This has resulted in rents declining by 4% in the second quarter from the fourth quarter of 2023. According to Integra Realty Resources, one of the top appraisal firms in the country, this has lowered net operating incomes which has caused cap rates to expand 23 basis points during this time to 6.42%. Flex industrial properties rose by 17 basis points to 6.93% due to the oversupply of new units.

Converting older industrial properties into modern industrial facilities due to the scarcity of industrial land for new developments has further fueled over supply, keeping prices low on remaining inventories. 

Retail

With high tenant demand, and the slowdown of negative metrics from e-commerce, retail is continuing to thrive during the second quarter of 2024. In fact, retail’s new method of combining e-commerce with in store person experience, is helping to fuel this market stability.                                                                                                           

Vacancy rates in the second quarter have held steady since Q1 2024 at 5.3% according to Cushman and Wakefield. This is due to a low market supply of new retail developments since 2020. Market rents rose by 69% over the past year in this sector to $21.98 per square foot by Q2 2024. However, there have been challenges for big box chains, and mixed-use developments. Large regional Shopping centers have a higher vacancy of 9.2% largely due to vacancy in their big box store spaces. 

During the first quarter of 2024, net absorption in all retail sectors contracted with net absorption turning this positive in the second quarter of 2024. However, year-to-date demand is lower by 91% than the second quarter of 2023. Even with these positive metrics, retail cap rates on all property types rose by 10 basis points to 7.25% during the second quarter of 2024 with small strip malls averaging 7.13% according to Integra Realty Resources.

In the second quarter of 2024, the average cap rate for net lease retail properties was 6.47%, up 5 basis points from the previous quarter according to CoStar.

Office

Record high vacancies along with negative absorption has continued to force a decline in value for office properties during the second quarter of 2024. This has been driven by more workers continuing to work remotely, and large corporations moving their operations to tax friendly states. With most banks not lending on office properties with low occupancy and a lack of national credit tenants, lack of capital has further forced office cap rates to expand. Property values in some large downtown urban markets experiencing more than 40% vacancy have been reduced close to the land value.

Vacancy rates for office properties continued to rise according to Integra Realty Resources, a national appraisal firm, during the second quarter of 2024 bringing overall vacancy to an average of 20.32% on A Class Properties, up from 19.8% in the prior quarter. B Class properties averaged 20.96%. Keep in mind that office properties with vacancy higher than 15% are considered distressed and are difficult to finance. The exception to this trend has been medical and biotech office space, which is thriving, with vacancy rates below 7%.

Return on investment further declined during Q2 2024 as more tenant improvement costs were shifted from the tenant to the landlord.  This has been exasperated by generous rental concessions which are often offered for the first year. 

With these metrics, office cap rates on A Class properties rose to 8.4% and 8.68% on B Class properties. Low occupancy C Class properties have hit a high of 9.02% according to CBRE.

Hotel

The lodging sector has evolved into a preferred commercial real estate asset class since late 2022, with many properties remodeled and reflagged. This has been due in part to the strong post-pandemic recovery. Hotels have proven to be resilient, and an inflation hedge as sophisticated revenue management allows for dynamic pricing of room rates on a continuous basis. Despite raised interest rates, the lodging sector is generating strong profits and investment yield opportunities. Cap rates have compressed from 7.25% to 6.08% on A Class Luxury Metro properties. B Class Suburban cap rates have decreased from 8.40% to 7.85% over the past year. 

While national hotel occupancy and ADR are still increasing, RevPAR growth is anticipated to taper in the third quarter of 2024. It is noteworthy that all hotel chain scales are anticipated to experience increasing RevPAR this year. The bad news is that on an inflation adjusted basis, real RevPAR levels are not expected to return to 2019 levels until later in the decade. Additionally, rising operational costs are creating margin pressure for owners and operators. New lodging construction is relatively muted due to a continued reduced inflow of new projects as compared to pre-COVID levels. However there has been a surge of remodeling and rebranding of dated hotel properties.  Elevated inflation and interest rates, and high labor and material costs will continue to hold back hospitality developers during the remainder of 2024.

June 2024 Cap Rate Report

Updated June 4, 2024

Cap Rates are Going to Continue to Expand

Commercial cap rates in 2024 are a gloomy continuation of 2023 for sellers, but may offer a more promising future for investors.  According to Moody Analytics, national average cap rates for the first quarter of 2024 on all commercial properties sold, expanded to 6.2%; an increase of 6.8 bps from Q4 of 2023. Multifamily cap rates expanded 33 bps to an average of 5.40%, and industrial cap rates expanded 22 bps to an average of 6.24% since Q4 2023. Self-storage has held value the best during this time with cap rates holding at 5.6%.                                                                     

Retail cap rates on mixed use and strip malls have held rather steady during Q1 2024 at an average of 6.8%.  Big Box stores due to the large number of vacant stores previously occupied by Bed, Bath and Beyond and Macy’s have expanded to 7.5% and regional shopping malls due to poor occupancy to 9.4%.  

According to CBRE, Office property cap rates have continued to rise the most with an average of 38 bps in Q1 of 2024 to an average of 7.8% which represented a 9% drop in value.   Between June of 2021 and December of 2023, office cap rates rose just over 200 bps which resulted in a drop-in property value of over 20%.  The office sector hit a new vacancy record according to Moody Analytics of 19.8%, up from 19.6% in Q4 of 2023.  This has been a result of many workers continuing to work remotely after the 2020 Covid19 pandemic and leases expiring that were not renewed.

Hospitality cap rates have compressed by 35 bps to an average of 10.2% during Q1 2024. This is due to the public’s increasing interest in travel, low vacancies and increasing net operating incomes.

This is a Time of Caution for Commercial Real Estate Investors       

Industrial, and self-storage properties will likely continue to perform the best during the remainder of 2024 and could represent a lower risk investment.  But for those who need financing they will still need to put a substantial amount down at today’s prices due to high interest rates.  This is a time of caution.  CBRE predicts further cap rate increases for the remainder of 2024 on all commercial property assets.  This means commercial real estate investors could be buying toward the top of the market with prices declining even further due to interest rates continuing to stay high and the market fundamentals of flat rental increases, rising vacancy, rising concessions and increasing operating expenses. It’s going to take interest rates declining and those market fundamentals improving considerably for this trend to become more favorable. 

Moody Analytics, expects commercial debt to reach a record high of $929 billion.  The greatest threat to lending institutions in 2024 is that 80% of the maturing office debt of $15.2 billion faces high delinquency risk. If interest rates continue to stay high, this will only compound the problem as the cost to repurpose these properties will not likely pencil.  

Rising Interest Rates Continue to Expand Cap Rates in 2023

May 18, 2023

From the third quarter of 2022 though the first quarter of 2023, self-storage and net lease industrial properties held their value the best, while all other commercial asset types experienced significant cap rate expansion with property values dropping 10 – 15%.    Office property cap rates expanded the most, increasing on average 125 bps. Cap rate expansion resulted mostly from high mortgage rates which created smaller loans, bringing real estate prices down on acquisitions.  It is predicted that cap rates will continue to expand through the third quarter of 2023 when interest rates peak, and then plateau during the last quarter according to CBRE.

To compound this trend, banks have been making qualifications more stringent for borrowers. With tightening by federal regulators considering recent bank failures, banks have been requiring stronger sponsorship, lower LTV’s, lower appraised values, and increased projected property expenses. This is their recipe for producing smaller loans and lowering risk.  Worse yet, many banks are not making any commercial real estate loans until rates come down, the economy strengthens, and the threat of recession wanes.  The result has produced a smaller pool of real estate investors that can qualify for financing, keeping buyer demand low.  If a recession is declared, many banks will have their higher LTV commercial assets reappraised and the ones that no longer meet their DSCR requirements will need to come off their books. This caused major cap rate expansion during the great recession of 2008.

Cap Rate Performance by Asset Class

Multifamily – This is the most sought-after commercial property asset classes.  Surprisingly, investors only purchased $6.2 billion nationally for apartment building properties in January of 2023, according to Real Capital Analytics.  Compare that to the more than $20 billion purchased in January of 2022.  Since the third quarter of 2022, this trend from investors has been making it a buyer’s market and expanded cap rates.    CBRE states that cap rate expansion started slowing considerably in March of 2023, and should continue at a slower increase though the third quarter of 2023 by about 25 bps. 

Self-Storage – With increased investor demand and very few properties for sale, this asset class has preformed the best of all commercial properties though 2022 with capitalization rates hitting an all-time low average of 5% in the fourth quarter of 2022, with net absorption up by 18.6% according to Cushman and Wakefield.  Cap rates have since plateaued and are expected to remain so through the third quarter of 2023 and then compress again in the fourth quarter of 2023.  

Industrial – This asset class performed third best since interest rates started going up in March of 2022, and is the third most in demand property for investors.   Net Lease industrial properties near ports had cap rates increase the most, while food warehouse retained their value despite the interest rate hikes.  Net lease big box warehouses had cap rates expand moderately. Overall, cap rates have expanded about 60 basis points in this asset class since March of 2022 and are expected to expand further in relationship to mortgage rates rising throughout the year.

Retail -  Anchored retail centers in suburban neighborhoods with strong tenant mixes have performed well since the interest rate hikes with cap rates expanding on average 50 bps since the third quarter of 2022 through the first quarter of 2023.  High inflation over the past year has benefited retail centers as prices on products have increased more than the cost of goods allowing for rental rate increases when leases renew.

Office – This asset class has performed the worst of all commercial real estate properties with cap rates expanding as much as 170 bps on older buildings with high vacancy rates. Many of these older buildings will have to be repurposed.  Compounding this downward trend is record high tenant rollover risk which makes it very difficult to obtain financing.  Medical office is an exception to this trend and is performing very well with cap rates up only slightly.

Hospitality – Since international and domestic covid travel restrictions were lifted, demand for business and personal travel has soared and this asset class is performing very well.  Still cap rates are high in 2023 ranging from 7.75% for world class hotels to 10% for economy hotels that have had their SBA loans increase from an average of 4.75% to 9.50% since March of 2022.  This is one of the most difficult asset classes to finance.

CAP Rate Forecast For 2023

UPDATED: January 5, 2023

As a commercial mortgage banker, it hasn’t been fun in 2022 trying to juggle the most rapid interest rate hikes since 1989 with the high prices on sales contracts. As rates kept going up, our loan sizes kept going down. Many of our clients got down on their knees to plead for price reductions so we could close their loans. More often, sellers just took their properties off the market which kept cap rates low. But the worst headache was having to inform investors they needed to put 50% down instead of the 35% they were expecting. After all, most had read the real estate books that pitch buying low and leveraging high. For most, buying high and leveraging low was deeply disturbing. This meant they would likely be settling for a 2% cash on cash return after their mortgage payment.  

By the third quarter of 2022, multifamily cap rates had remained flat, and there was a slight increase for industrial, office and retail according to Moody Analytics https://cre.moodysanalytics.com/insights/market-insights/the-fed-and-banks-are-putting-the-squeeze-on-multifamily-cap-rate-spreads/. The rule of thumb is that cap rates compress and push values up as a result of a strong economy evidenced by low inflation, low unemployment, a strong GDP and substantial rental increases. But it takes one more factor to really push prices up and that’s low interest rates which we had through February of 2022. Although we did have good job growth and rental increases in 2022, and GDP came in higher than expected at 2.9% in the third quarter, we had the highest inflation in 40 years combined with the most rapid increase in mortgage rates in 33 years. Cap rates should have gone up a lot more in 2022. 

Going into 2023 most of the real estate investors I talk to have their brakes on. Why?  Because they have absolutely no idea what properties are really worth today and they can sense they are buying at the top of the market. To add insult to injury, they know that high inflation increases operating expenses – so most are adding at least 6% on. And face it – it’s really annoying to pay today what a property may be worth in 2 years based on its current net operating income. And that’s only if you’re lucky to raise rents enough. And sellers have their brakes on too. They know that high mortgage rates mean this is not a good time to sell. 

It is evident that cap rates in 2023 simply cannot go anywhere but up. Why? Because of the double whammy of high interest rates combined with the high sales prices inherited from 2021 and 2022. I didn’t think those high sales prices were supported by reality back then and I don’t think they are now. Reality being what renters can afford to pay with high inflation and the return on investment (ROI) that real estate investors expect to earn. And while we’re at it, we better include what investors can afford or are willing to put down on a loan. So, in 2023, it’s time for a reality check.

Since the third quarter of 2022, commercial real estate sales have slowed according to The National Association of Realtors https://www.nar.realtor/blogs/economists-outlook/commercial-real-estate-is-slowing-down-in-q3-2022. According to Bloomberg, prices fell 13% during that time frame. https://www.bloomberg.com/news/articles/2022-11-04/us-commercial-property-prices-slide-13-from-peak-as-rates-jump?leadSource=uverify%20wall. So there has been some movement upwards on cap rates.    

I expect supply and demand to remain low in 2023 as sellers wait for rates to come down and buyers wait for prices to come down. I predict cap rates to go up by 100 bps in 2023 rising slowly at the beginning. Keep in mind as we go into this new year, most sales comparables used by appraisers to determine current values, will be from the high prices of the past 2 years which will keep cap rates low for a while. With mortgage rates expected to stay high, eventually there will be enough sellers that have to sell to bring prices down – especially if there is a recession by mid – 2023. Based on all of the above, I predict cap rates will increase by .40 bps during the first 6 months of 2023 and then go up by another 60 bps in the second half of 2023.     

Where are Cap Rates Headed?

By Terry Painter, Mortgage Banker, Author of: “The Encyclopedia of Commercial Real Estate Advice” Wiley Publishers

UPDATED 9/7/2022

I have worked as a commercial mortgage banker for the past 25 years and have encountered many surprises. But nothing that equals the call I got last week from a client that was making an offer on a 36-unit, C Class property in Greenville, South Carolina. “Are you seriously going to buy this property at a 3.76 cap?”, I asked him.

The seller had owned the property for 16 years and had hardly raised rents in this blue-collar neighborhood during that time. But really? A 3.76 cap? Earlier this year I closed a multifamily loan on a B class property in Santa Monica, California at a 3.25 cap which made perfect sense in that neck of the woods.  

Have cap rates on multifamily properties gone completely nuts? How is it that a C class property in a working-class neighborhood in South Carolina can be offered at close to the same cap rate as a B class property in one of the most moneyed areas of California?  And why was my client willing to pay such a high price for a property that did not have the net operating income to support it? Stay tuned. I will get to that in a moment. 

Why Cap Rate Compression today is almost Scandalous 

Historically, cap rate compression (the lowering of cap rates) occurs naturally because of rents going up over time creating more net operating income and higher property values.This is often accelerated by a process called forced appreciation when rents are pushed up by cleaver investors that implement value adds. But what’s happening now is an anomaly due to the four factors in play below. What seems almost scandalous are the high number of sellers that haven’t bothered to upgrade their properties or increase rents that are being rewarded with insanely high sales prices for doing absolutely nothing but being at the right place at the right time. 

4 Reasons Cap Rates on Apartment Buildings Have Been Compressing

1. Low-Interest Rates – Cap rates have been coming down on apartment buildings pushing values up at a rapid rate since the recovery phase of the great recession in 2010, and even more so during the corona virus recession of 2020. During both recessions the Feds purchased an unprecedented amount of treasury and mortgage-backed security bonds that kept long term interest rates artificially low.  These record low rates supported a much higher loan amount which made it feasible for buyers to get financing at a much higher sales price. 

2. Supply and Demand – Just as in the housing market, the corona virus created a record low inventory of multifamily properties for sale as buyers and sellers insulated themselves from each other. Once it was safer for people to mingle again, many sellers were reluctant to put their properties on the market, thinking prices would go up even higher.

3. Low Construction Starts – in March of 2020, the corona virus pandemic scared most lenders from making construction loans on projects already in the works.   About 6 months later these lenders were eager to lend again. But by then, the supply chain calamity increased the cost of materials and labor making it economically prohibitive to build. Fortunately, the cost of materials is coming down now, but labor is still at an all-time high. To add insult to injury the feds raised prime rate (which most construction loans are based) 2.25% between March and July 2022. This lowered loan amounts and increased construction cost.  

4. Record High Rents and Low Vacancies – With the cost of homes skyrocketing, more Gen Z first time home buyers were sidelined into the rental market, pushing rents up by over 10% in 2021 and over 15% annually through June of 22 according to Redfin.  According to Moody Analytics, multifamily vacancies hit a 20 year low of 4% in the second quarter of 2022.

So, now getting back to why my client was so eager to overpay for the property mentioned earlier. He’s actually a smart guy who owns an apartment building down the street that is full with a waiting list. The property he wants to buy is in good condition with under market rents. All he has to do is raise the rents 60% to market rate and he will hit a home run. 

Will Multifamily Prices be Coming Down Soon?

It seems evident that multifamily sales prices have reached their peak. Sales for multifamily properties started dropping in May 2022 due to increased interest rates according to the National Multifamily Housing Council. Another telling factor is that  multifamily starts (5 Units +) increased by 18% year to date through June in 2022 according to the National Association of Home Builders and will add 300,000 new units to the market in 2022 according to CBRE.  

With historically high inflation, rising interest rates, and the gross domestic product (GDP) being down for two consecutive quarters, a recession could be looming around the corner. If this happens will prices come down? Not likely. Unlike the great recession where vacancies and delinquency on rent payments dangerously increased due to high unemployment, the opposite is the case now. And most sellers today have savings plus good incomes and can afford to wait to get the prices they want. With or without a recession, it’s more likely prices will flatten for quite a long time, with demand for units remaining high. And with the stock market being a roller coaster ride, more investors will view the high prices of multifamily real estate as a safe haven.   

What Commercial Properties have Cap Rate Compression Today?

Cap rate compression means cap rates are coming down and commercial real estate values are going up.  This has been occurring at a breakneck since the recovery phase of the Great Recession ended in 2012 and the expansion phase was well on its way.   In January of 2022, the most popular commercial real estate for sale – we are talking about multifamily, self-storage and industrial properties held steady in the 4.50 to 5.70 cap rate range.  What is clear is that these properties are holding on to the cap rate compression generated in 2021.  The question is, can cap rates continue to hold, or will they come down?

I like to compare commercial property value to an elevator.  All elevators go up and down and have a top floor. With recessions occurring on average every 6 years bringing prices down, and commercial property values usually caped by their net operating income, this effects the amount of cash buyers can put down, which should hold prices down.   But in today’s low cap rate environment, it appears that the commercial properties mentioned above will continue to increase in value and more floors will be added for this symbolic elevator.  This is primarily because of the laws of supply and demand, and as there is a shortage of these properties on the market they are going at insanely high prices.

What enables these prices to skyrocket?  Well, for one thing more 1031 sellers were offered prices they could not refuse and have ploughed profits into overpriced replacement properties driving down cap rates.  To compound this further, new ground up construction starts for these property types have been at a snail’s speed, or nonexistent since the corona pandemic started.  Once there are more properties built, cap rates should level off or come down a bit.

What Commercial Properties have Cap Rate Expansion Today

Cap rate expansion means cap rates are going up and property value is coming down. It’s obvious that office, retail, and hospitality properties are in this group.  With so many workers working remotely at home, many large office properties where largely empty during the pandemic.  Although most of these businesses paid the rent, occupancy on many office properties fell to 85% or below.  This labeled them as distressed bringing their property values down. Also, many tenants have been hesitant to sign long term leases, which created tenant roll over risk for lenders. This meant someone interested in buying an office property would have to put a lot more down and most likely have to use more expensive financing.   

Retail properties were also hit hard by the pandemic.  Many retail tenants were already hit hard by the trend to buy online and then their businesses were restricted by too few customers.   The uncertainty in this sector created it so that many retail tenants – especially restaurants and apparel stores did not sign longer term leases, again creating tenant roll over risk.  This has made it difficult for these properties to be financed and caused their values to come down and cap rates to rise.

Hotels, initially got hit very hard by the pandemic with so few people traveling.  This caused operators to make special arrangements with their lenders and greatly increased lender risk.  Hotels seem to always have a difficult time during recessions and we did have the corona virus recession.  Although many larger hotel chains have shown good signs of recovery lenders are still scared to finance them.   Smaller mom and pop operations are still struggling. The result has been, if they want to sell, their poor financials end up pushing the price down.

THE SHOCKING TRUTH ABOUT CAP RATE

“There must be some mistake” Rick, my client said to me. “How can my property only be worth $5.25 Million when the exact same property 4 miles away sold for $5.6 million last year.” In fact, he was right on. He had gotten the blue prints to build his new 36 unit multifamily complex from his brother-in-law who had built and sold the exact same design last year. Rick’s apartment complex to be built, and his brother-in-laws were both located in adjoining sub markets in North Dallas. Rick had recently applied for a construction loan and the appraiser stated the completed stabilized value for less than an identical sale. Now his construction loan would be $262,500 less because of the appraisal. How could this happen? Because of Cap Rate. 

There Is An Inherent Conflict of Interest Over Cap Rate Between Appraisers and Lenders.

It is important to understand that capitalization rate is the foundation for supporting the purchase price in the sale of a commercial property. But it actually originates from the income approach in a commercial appraisal. For lenders, the income approach is king.  Furthermore, appraisals are not an exact science. In fact, they are far from it. In my 21 years working as a commercial mortgage banker and loan broker, I have read hundreds of appraisals and have been shocked, amazed and sometimes amused by them. When an appraiser starts researching the data for their report they can either start with a blank slate – with no expectation for a value, or they can start with an expectation based on cap rate for a value and then do the research to support that value. Please understand, there are appraisers that have the highest integrity and genuinely research the facts to come up with unbiased, very accurate reports. But there are also appraisers (who are not going to like me for saying this) that start with where they think the lender will be happy and then bring in the data to support that number.

What I am saying is that there is often an inherent conflict of interest between many commercial appraisers and the lenders that hire them. This is simply because of one or more of the following:

• The appraiser wants to please the lender, not have their reports challenged by the lender and get hired again by the lender.
• Most lenders just do not feel safe making a loan based on a cap rate in a sub market that has recently gone down – increasing the property value and commercial appraisers certainly know this.
• Lenders do not like to be the first at something. I have even had some lenders tell me that they are going to underwrite the loan to a 7 cap even when it is obvious that recent sales comparables have supported a 6 cap. This means that even though they say they lend up to 75% of value, they might really only lend up to 70% of value. After all, lenders know that although it does not happen often - property values can go down. So there is an innate pressure for an appraiser to support the valuation that they know the lender will feel comfortable with. 

There is an Inherent Conflict of Interest Over Cap Rate Between Commercial Realtors and the Property Values their Offering Memorandums Support.

Just as for appraisers, listing agents for a commercial property can have a conflict of interest in how they support the property values they show. This is obvious when you read through many offering memorandums and find that some of the conclusion of value is based on projected rather than actual numbers, and sales comparables that have a large disparity when compared to the subject property. This marketing can be misleading in that often the comparables are not like properties in age, quality of tenants, leases, amenities, and location. Again, there are commercial realtors that have great integrity and support their listed property values based on actual numbers and actual comparable sales. 

To make this simple, this is essentially what the listing agent may do. In order to get the listing, they tell the seller that they can get them this great price which let’s say has the subject property selling for a 4.7 cap. Let’s say that like properties in this sub-market are actually selling for closer to a 6 cap. Of course, the lower the cap rate, the higher the property value. To start with they will sell the property based on its potential income, not it’s actual income. This immediately increases the net operating income and lowers the cap rate. Next, they will search for sales comparables in like properties that support this value. 

MORE ON CAP RATE

Cap Rate stands for capitalization rate and is used in commercial property valuations. Cap Rate is simply the net operating income (income minus expenses) divided by the purchase price or appraised value.

The cap rate or also in full – capitalization rate – is one of the most important figures to understand if you are an investor or potential investor in commercial real estate investment property, or selling investment properties. The cap rate is something you should especially become familiar with if you are new to investment in commercial real estate property.

Why is the cap rate so important? Because commercial lenders, commercial realtors and commercial appraisers all use cap rates to accurately find a commercial property’s current value. And, you should too. After all, if you want to buy a commercial property, don’t you want to know its accurate current value?

So what is cap rate or capitalization rate? It is the net operating income divided by the purchase price or appraised value. It is also the rate of return you get on the property based on the income the property is earning. An income property investor can not accurately determine their rate of return on their investment without applying an accurate cap rate to the property.

The formula for figuring a cap rate is:
Net operating income/property value or purchase price X 100

Example 1
You are looking at buying a multifamily property in Denton, Texas for $2 million. You are planning to pay for it in cash. You want to find out the annual percentage of interest you would be earning on this piece of property.

Let’s say that the multifamily property’s net operating income (subtract expenses from gross rents) is $180,000 annually. This means that you are earning 9 percent annual return on your investment. From the above formula $180,000/$2 million X 100 = 9 percent. This means it is a 9 cap. You would be earning 9 percent on your investment.

Example 2
You also want to purchase a multifamily property in Los Angeles listed for $2 million and it has a cap rate of 5.5 percent. This gives you an annual earnings of $110,000 after taking off expenses and prior to looking at the cost of financing.

Many of our clients at Apartment Loan Store live in California where cap rates are very low and they purchase properties in locations like Texas, Oklahoma, or South Carolina, where they can get properties with a higher cap rate. They want a higher cap rate because the higher the cap rate, the greater amount of money is earned on your real estate investment.

However, there are customers of ours who want to buy 3 cap properties in costly locations like Santa Monica, California. They have a preference for nicer properties in expensive areas. One potential disadvantage of properties that are very high cap is that they can be in need of extensive repairs and could be in neighborhoods that have problems such as high crime, and poor upkeep. 

The first thing commercial real estate lenders look at is the cap rate to see if there is accurate assessment of the value of the property. This is based upon market income as well as expenses for properties that are similar.

On the other hand commercial real estate realtors base pricing on market cap rates in that particular sub-market. They definitely do not want the property to have an appraisal that is less than the price of the property because it very well could mean the loss of a sale.

Three Approaches in a Commercial Appraisal

There are 3 approaches used in full commercial appraisals. The income approach is the most important and is based on cap rate.

1. The cost approach – based on what it would actually cost to build or replace the property today.

2. The sales comparable approach – based on like comparable sales.

3. The income approach – based on cap rate determined by rent, income and expenses on similar properties.

To get the final valuation, you take the average of both the sales comparable approach and the income approach.

Again, the basis of the income approach is the cap rate. Capitalization rate orginates from the sales comparable approach in commercial appraisals. There will be a comparison between 3 to 5 different similar properties that have sold, and the subject property. The way you get the final value of the income approach is to take an average of capitalization rates that the properties that were comparable were sold at.

By Terry Painter/President    Apartment Loan Store and Business Loan Store