Are Cap Rates Telling Us Anything?

Capitalization rates, or cap rates, express the return on invested capital in commercial real estate (CRE) investments. it's derived by dividing the net operating income (NOI) produced by the property by the total capital invested in it. As property values increase, cap rates decrease. In the street patios, this means that the more you pay for a property, the lower the rate of return if NOI remains unchanged.

The ING Clarion recently reported that cap rates indicate CRE currently is undervalued by the standards of the past 10 years. At the height of the recent real estate frenzy, cap rates for some core assets were as low as 2% - even more in some cases. Now, Real Capital Analytics reports them to be in the range of 7.5-7.8%, which is slightly above historic averages for various property types.

It's always dangerous, however, to generalize about real estate. While macroeconomic factors are involved, all real estate is local; thus, the relevance of cap rates is based on local market conditions as well as the unique aspects of a particular property. For example, an office deal went down in Seattle several weeks ago that reflected a cap rate of 5.5%. BUT it was a class A core asset with a creditworthy tenant  occupying 90+% on a lease that runs thru 2024 with another 6% also under lease. In a different situation, with a class C building at 70% occupancy on short-term leases with tenants of questionable creditworthiness, the cap rate could be at 10%+. 


The reality is that the only cap rate that matters is the one generated by the property you're acquiring, and that's largely a matter of the property's characteristics and local market fundamentals.