What Is Cap Rate In Commercial Real Estate?

There are a lot of calculations and variables to understand if you choose to purchase rental residential or commercial real estate. The “cap rate” is one of the first concepts you’ll encounter. What is a cap rate in commercial real estate, what is a good cap rate for commercial real estate, and what does this number mean for your investing decisions? Let’s investigate this critical metric in more detail.

In spite of its ups and downs, real estate remains a safe and stable vehicle for many investors across Canada. When it comes to commercial properties, the sky really can be the limit for those with the funds and experience to partake.

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Cap Rate Meaning

What does cap rate mean? It’s one of the first metrics an investor will use to determine whether or not a particular property could be profitable. The name is short for “capitalization rate,” which represents the potential annual income without taking market appreciation into account. Understanding this number will help you assess the risks associated with a certain investment.

There are many differences between residential and commercial real estate, but also some similarities. You’ll find valuable insights for both in the posts below:

How To Calculate Cap Rate

Commercial real estate investing may be highly nuanced, but the calculation for the cap rate formula is simple. You can likely find a cap rate calculator online; otherwise, it’s easy enough to fill in the gaps using good old-fashioned math.

First, estimate how much income you reasonably expect to earn from the property. Next, subtract all operating expenses, such as taxes and insurance. This results in your Net Operating Income (NOI).

The last step in the cap rate formula is to divide your NOI by how much you will pay for the property. This is your cap rate percentage. Your decision to invest or to keep searching will be largely based on this formula.

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What Is a Good Cap Rate?

Is a higher cap rate better? Whether a cap rate is desirable or not depends primarily on your investor profile. High rates tend to indicate a more volatile investment. It doesn’t necessarily mean it’s bad. Often, it means there’s a greater potential return, but the risks are also higher.

Low cap rates typically mean a lower return, but they also come with fewer risks. For example, a well-maintained building in a high-traffic area could be a premium opportunity. However, a steep purchase price will lower your cap rate significantly.

A healthy cap rate for commercial real estate might look like the following:

3-5% likely suggests a stable but modest return.
5-7% offers a balanced return and some manageable risks.
8-10% comes with a substantial amount of risk, but also a high potential for equity growth.

GTA Cap Rate Explained

The GTA is known for its high price tags when it comes to real estate. Commercial properties can be even more expensive. However, the possible rewards make it well worthwhile when you find the right opportunity. Let’s take a look at a hypothetical situation so you can see how the cap rate formula might affect your decisions in the real world.

Imagine a mixed-use building has recently become available in Toronto’s East End. After consulting with your commercial real estate agent and running the numbers, you estimate an approximate income of $180,000. (The actual potential could very well be greater, but we want to keep our estimations modest to help reduce the risk.)

Next, we estimate that it will cost $60,000 to carry the property (not including the mortgage). Again, expenses might be lower, but we want to err on the side of caution.

By subtracting our total expenses ($60,000) from the total income ($180,000), we come up with a Net Operating Income of $120,000.

To keep the numbers simple, imagine the asking price for the building is $2.5 million.

Divide $120,000 by $2.5 million, and we have a cap rate of 4.8%.

Thinking about buying or leasing a property? The posts below can guide you through the process:

What Does the Cap Rate Mean for My Situation?

It all depends on what you’re looking for. Are you buying the property to generate an income, or is equity growth your primary concern?

By all accounts, a property with a 4.8% cap rate is a great find for an investor who wants a modest yet steady return with minimal risk. A more aggressive investor will likely seek out a building in a lower-demand and hopefully up-and-coming area. For example, you might find a property just outside the city with a purchase price of only $1 million. With a NOI of $100,000, you’d have a cap rate of 10%.

The initial income may be slow, but there could be vast potential for equity growth if that sleepy location goes through a period of rapid development. However, that might also be a long shot, and in the meantime, you have higher vacancy rates due to less demand from tenants.

Keep in mind that you might find yourself carrying the property at a loss until the area takes off. Sometimes, growth does not happen as expected, or ever. Speculative properties like this are often only suited to experienced investors who can withstand the risk.

Before deciding on a property, it’s critical to have clear goals in mind, as well as a contingency plan for riskier investments. An experiences commercial real estate agent who thinks like an investor can help you better understand the risks and opportunities of any venture you are considering.

A commercial real estate Toronto specialist is an essential partner when buying, selling, or investing in industrial properties. Connect with me at OMarjanovic@kw.com or call 647.620.2882 to learn more.