In commercial real estate, the capitalization rate or “cap rate” is a formula utilized to analyze real estate markets and compare investment opportunities. A property’s capitalization rate can be calculated by dividing its net operating income by its purchase price. The cap rate provides a snapshot of a property’s earning potential. Both investors and business owners utilize cap rates when shopping for commercial real estate, as a higher cap rate means a higher return for the investor.
Net Operating Income /Purchase Price = Cap Rate
In the example below, an investor purchases a doctor’s office for $500,000. The property has a long-term tenant, with a 10-year NNN lease. The monthly rental income is $2,500, with an annual net income of $30,000. In this scenario, the property’s cap rate is 6%. In addition to providing a measuring stick to compare similar properties against, cap rates provide investors with an expected rate of return. In this scenario, the 6% cap rate means the investor received a 6% annual return on their capital (in addition to any appreciation).
6% = $30,000 / $500,000
A property’s cap rate offers a very practical way to analyze its value, by comparing its earning potential and purchase price. Like a weather barometer, cap rates can be used to measure the economic health and investment activity within a community. Currently, national cap rates for commercial properties range from 4% to 10%, with Reno’s cap rates ranging from 5-7%.
In today’s low interest rate environment, with money markets paying less than 2%, local commercial real estate continues to offer investors 5-7% annual yields. Known for being a stable asset class that preserves wealth, commercial properties remain an attractive investment for individuals, businesses, retirement plans, and trust funds.