The lifeblood of commercial real estate investment is scales of comparison, with potential investment returns laid bare using a handful of key metrics. The most basic of those tools is the capitalization rate (or ‘cap rate’). Yet, for more experienced investors seeking a competitive edge, the cap rate’s finer points can prove crucial.
Cap Rates: Unveiling the Investment Potential
While cap rates can help you discern the income-generation story of a property when compared with others, the true power of the cap rate is its ability to tell you about a property’s potential risk-adjusted return. The cap rate tells you the annualized return you will make on the deal based simply on the NOI for the property and the current market value of that property. Yet, even the smartest of investors understand that the cap rate is really just the tip of the iceberg.
Dissecting the Cap Rate: A Multi-Faceted Lens
Going beyond the formula can help to provide a more nuanced understanding of the drivers of cap rates, which can, in turn, help you to make more informed investment decisions. Here are some of these key drivers: Arbitrage: Since cap rates are typically inversely related to prices, industrial warehouses with cap rates somewhere around 10 percent could have lower pricing than offices in central London, say, where cap rates of 3 or 4 percent are common. If cap rate arbitrage means buying an appreciating asset, we might wonder when its underlying principles, logic, and rationale were violated. Cap rate insanity might have set in when real estate abdicated its usual role as a real thing because the ‘alternative’ historically riskless asset we’d been accustomed to counting on for security was practically superseded by real estate. The granularity of location: Go beyond the prime location to understand submarket dynamics and the development pipeline, which can unlock value (or create risk) not captured in the headline cap rate. Market Cycles and Trends: The broader commercial real estate market also plays an important role in cap rates. Understanding how a cap rate relates to current market conditions (see one of your blog posts on current and forecasted commercial real estate market trends) helps you know if a cap rate reflects an opportunity to buy or a potential correction. The quality of tenants matters: solid, credit-worthy tenants demand lower cap rates. Pay attention to tenant financials and their form of rental agreements to evaluate the merits of the income stream.
Beyond the Cap Rate: A Holistic Investment Approach
Cap rates are a useful tool but not the final arbiter of whether one should buy an investment. Here are three more things to think about:
Style Report: A condition assessment of property features can identify capital expenditures for maintenance or replacement that may reduce future income or increase operating expenses.
Long-term growth potential: Don’t just be concerned with monthly returns. Look at the potential for rents to increase and the overall value growth over time. Market growth path: check what projected growth is like around there and in relation to future rental income. Planned developments: nearby planned developments can greatly enhance a property’s price and long-term estimated return. Due diligence: Investigate thoroughly before buying by researching property records, reviewing tenant leases, and determining all expenses.
Conclusion: Mastering the Art of Investment Analysis Using cap rates effectively as a sword alongside a deep examination of all the other factors should give you the confidence to invest in the commercial real estate market. Cap rates are one measure of a property, but other measures are equally important. If you use a sword as a hammer, you might kill someone by mistake.
