What Commercial Real Estate Investors Should Know About Cap Rate


CAP rate or capitalization rate is the ratio of annual rental income of the property over the purchase price. This number is often shown on commercial property listings. So you must know this jargon if you want to invest in commercial real estate. It’s commonly a number between 3% to 10%. The higher the CAP rate the higher rental income the property produces and thus the less money you need for down payment. Experienced investors often look at the CAP rate to screen out properties with low rental income. Some investors prefer properties with the cap rate that is higher than the interest rate they pay for the loan. That way they know they collect more from the tenants than they pay the bank. When the property has high vacancy rate, listing brokers often show proforma (or potential) CAP rate instead to catch investors’ attention. Let’s use the following example to illustrate the point. A property is listed for $1M and is 90% leased. It has gross leases with an actual gross income of $90K/year and $30K of annual expense. Assuming the proforma income is $110K/year when it’s 100% leased at higher market rent. So 3 different listing brokers could display 3 different CAP rates for the same property:

• The first broker may use NOI (Net Operating Income) of $60K/year ($90K of gross income less $30K of expenses) and thus the net CAP rate is 6%. This broker calculates the cap the way it should be.

• The second broker may use the gross income of $90K and so the gross CAP rate is 9%.

• The third broker may want to use the proforma income of $110K to get investors’ attention and thus the proforma CAP rate is 11%!

So as an investor, you need to know what CAP rate, e.g. net, gross or proforma the broker uses. Otherwise you may offer too much for the property. At the same time, when you tell your broker to look for properties with a certain CAP rate, make sure the broker knows what CAP rate you have in mind.

The returns of a commercial property investment come from 4 sources: appreciation, cash flow, i.e. cap rate, depreciation (tax writeoffs), and principal reduction from your mortgage payments. If you invest in the “right” property, the biggest chunk of your investment return should come from appreciation. There is often a conflict between cap rate and potential for strong appreciation. Properties that offer potential for strong appreciation, e.g. newer properties or ones in good location tend to have lower cap rate. On the other hand, properties that are in poor condition, or have ground lease are much harder to sell. As a result, seller will try to attract the buyers with a higher cap rate. If you see a property with unusually high cap rate in California, e.g. more than 7%, you should ask yourself “what’s wrong with this property?” Chances are you will find a compelling reason why it is so high.

Is the property with highest cap rate the “best” property? The short answer is no. If investment was that simple, you would not need an investment advisor. Cap rate should be one of the various other factors you consider whether you should invest in a property. It should not be the only factor. Besides, you can improve the cap rate by

• Increase the occupancy rate.

• Raise the rent when the current leases expire.

• Negotiate for leases with annual rent increase.

• Bring in tenants willing to pay higher rent.

• Improve the property to attract more upscale tenants.

• Reduce the expenses not reimbursed by the tenants.

By doing so, you can increase the cap rate and consequently the value of your investment.

What Is The Best Commercial Real Estate Loan?


This question came from Kiho Kim in Anaheim, California and, surprisingly, doesn’t have a straightforward answer. When someone asks me that question, I know that they’re probably focused on one thing: The loan with the lowest interest rate. Unfortunately, in commercial real estate, this approach can end up costing you a lot of money.

When you get involved in commercial real estate, you become involved in a more sophisticated method of investing your money. Commercial real estate and commercial real estate loans have a lot of “moving parts” and the approach that commercial lenders take is far different from those in residential lending. When considering financing on a piece of investment property, you have to approach the process with ”commercial mortgage planning” in mind.

What is commercial mortgage planning? It’s a process in which all aspects of the loan are considered in the context of the commercial real estate investor’s current portfolio, future portfolio goals, style of investment, and cash flow needs. Let’s see how this works in a practical example and then use that example to further answer the original question in the first paragraph.

Which is the best loan? A 3/1 ARM with a declining 3 year pre-payment penalty of 3%-2%-1%, a rate of 6.75%, a full amortization of 30 years, and a margin of 2.50% over 6 Month LIBOR, or a 10 year fixed rate loan due in 10 years, with a 30 year amortization, at a rate of 5.9%, with a Yield Maintenance prepayment penalty until 9.75 years have passed?

On the face of it, the 30 due in 10 is almost a full percentage point less in rate! No brainer, right? Let’s fill in a few more details and see if this analysis stands.

The investor contemplating the loan is an active real estate investor who purchases properties that have vacancies or month to month tenants that are slightly run down and in need of upgrades. He holds properties until re-tenanted, renovated, and then sells them to generate cash for new purchases in a 1031 Exchange to preserve his buying power.

In light of this information, the 30 due in 10 would be a terrible loan. It’s likely that such an investor would be ready to sell the property in the 3rd year to take advantage of the 1031 Exchange holding period and provide a stabilized leasing history to a new buyer. He’d only face a 1% pre-payment penalty using the 3/1 ARM, something he could easily factor into his “costs.” The fixed rate loan with its Yield Maintenance pre-payment penalty could literally cost him hundreds of thousands of dollars, depending upon market conditions, when he goes to sell the property. In fact, it would likely contain a “lock out” clause completely preventing a payoff for up to 4 years. That loan would have to be assumed by the new buyer and the difference made up in cash, limiting the potential pool of buyers for that property.

So how does this example answer our question: “What is the best commercial mortgage?” This way: “The best commercial mortgage is the one that best fits the commercial investor’s short and long term goals, risk tolerance, investment style and the investment at hand.” And as a side note, be sure to work with someone experienced not only in commercial loan brokerage, but who will take the time to consider all of the factors that could affect the current and future transactions.