Capitalization (cap) rates are the most commonly used metric by which real estate investments are measured. Which begs the question – what is a good cap rate for an investment property? As with any complex topic, the answer is that it depends.
It’s important to remember that a property’s cap rate is simply its annual net operating income (NOI) divided by purchase price, and represents the unlevered annual return on the asset. Because one of the driving factors is income, often times cap rates are “projected” based on an estimate of future income.
Different cap rates between properties should, in theory, represent different levels of risk. A lower cap rate should correspond to a lower level of risk, while a higher cap rate should imply more risk in the deal. As an investor, the challenge is to determine the appropriate risk-adjusted return, or in other words, the right cap rate gave the riskiness of the deal.
When analyzing a potential investment property to determine the right cap rate, there are several core factors one can look at, including location, asset type, and the prevailing interest rate environment. Let’s examine each to see how they affect cap rates.
You are likely familiar with the old adage “in real estate, location is everything”. This is because the value of any real estate property is driven by demand, and that demand is largely affected by the location. Location can refer to both the Metropolitan Statistical Area (MSA) property is in (e.g. Seattle vs. New York), and where within that MSA (e.g. urban vs. suburban) it’s located.
As you can see, investors were willing to accept an average 5% lower annual return in Los Angeles vs. the same type of asset in Memphis. Why? Because they perceive Los Angeles to be a less risky market based on its fundamentals. LA has a larger, wealthier, and better-educated population, which drives a more dynamic local economy and should make a demand for office space stronger over the long-term.
Within the Market
As anyone who lives in or near a major US city knows, home prices are generally higher the closer you get to downtown. The same is true of commercial real estate, where prices are higher, and cap rates, therefore, lower, in the central business district (CBD). Investors are willing to pay more for CBD assets because, as you might have guessed, they perceive the risk to be lower than in the suburbs.
This goes back to the fundamentals of real estate being a scarce asset with intrinsic value. There is only so much land available in the CBD, and there is a natural demand for it because it’s close to other businesses and key infrastructure like mass transit, ports, highways, etc.