What is the cap rate and how important is it when valuing commercial property? The simple answer is very important. But despite this, it’s a term that is often misunderstood, especially by those not as familiar with commercial property ownership or investment.

 Put simply, the cap rate is the ratio of net operating income (NOI) to a property’s value. [NOI is revenue minus operating expenses. It excludes principal and interest payments, capital spending, depreciation, and amortisation.] So, as an example, a small commercial office that had a NOI of $50,000 and had a current market value of $750,000, would have a cap rate of 6.6%.

But what does this 6.6% mean?

 First, it allows investors to assess different investment opportunities and the relative expected contributions to overall return from NOI and capital appreciation. When comparing a property with a 6.6% cap rate to a property with a 10% cap rate, the market expects the 6.6% cap rate property to have higher future appreciation to offset the lower NOI compared with the 10% cap rate property.

 The NOI for the 10% cap rate property also may be more uncertain and the extra NOI is required to offset this risk compared with the 6.6% cap rate property. However, expectations regarding the future aren’t the same as realised outcomes, so only time will tell whether the property value performance and realised NOI are sufficient to offset the difference between the cap rates.

Take, for example, a fully tenanted, small office block in a sought-after suburb compared with a similar-sized property in less prominent part of the city. The former will have a lower cap rate because its value will be higher, being in a better location; the latter a higher cap rate reflecting a lower market value and greater risk associated with the property income. An investor prepared to take more risk might acquire the property in the second suburb; the conservative investor will be inclined to pay a premium for a fully or easily tenanted office in a better location. What this means is that there is no ideal cap rate – it all comes down to the market and an investor’s appetite for risk.

Second, by assessing the cap rates of comparable commercial property sales in the same location, investors have a common guide on relative value as to the value of the property they want to acquire. If similar properties have been selling close by, the cap rate of these properties applied to the NOI of the property under consideration will give an approximate guide to what the market assesses the value to be. However, property, tenant or lease specific factors can override this rule of thumb and care must be taken in drawing general conclusions.

It’s important to remember that cap rates, like any investment ratio, have their limitations. For example, consider NOI. When it is stable, the cap rate will be invaluable in making an investment decision. But if the NOI is complex and irregular, then it is a different ball game. Certainly, any investment should consider the myriad factors that can influence NOI such as building quality, location, tenant diversity and creditworthiness, length of leases and the broader economic outlook.

Currently, in the Australian market, rising interest rates have reignited the debate about how much impact this will have on cap rates for commercial property. The economic logic says the higher cost of borrowing, the less debt a property can support with its NOI, causing property prices to fall. This in turn will increase cap rates.

But that assumes steady NOI. And not all is necessarily as it seems – for two reasons.

Rentals for many commercial properties are increasing due to continued strong demand in the economy (the unemployment rate fell 3.4% in July, the lowest rate in nearly half a century) and/or higher inflation if the lease has inflation linked rentals. Rent increases translate into a higher NOI and downward pressure on the cap rate. Consequently, softening cap rates due to rising borrowing costs may be partly compensated by rising rental income, as income, not property values, slow cap rate increases.

This trend for commercial property is likely to be even more evident for industrial property. Recently released figures from the global commercial real estate services company JLL show prime industrial rents rose 6.22% between April and June to be up 14.9% annually.

As long-term bond rates rise so typically should cap rates, but often not at the same pace and often not to the same degree, depending upon the commercial property itself and the sector. This is currently happening in our markets with the change in cap rates for retail, office and industrial being quite different as noted above.

Another complication is the cap rate’s relationship with long-term interest rates – the 10-year Australian Government bond. The 10-year bond rate is a proxy for the risk-free rate of return for long-term assets. As commercial property has additional risks compared with Government bonds, if the 10-year bond rate increases, the cap rate would be expected to increase as well to maintain the risk premium. The increase in cap rates, though, is often not at the same pace and very often not to the same degree, depending upon the commercial property sector and how the market assesses the risk premium. This is happening in our markets with the change in cap rates for retail, office and industrial being different.

What all this is saying is that the cap rate is a useful guide to commercial property valuation, but it is not infallible. When making a commercial property acquisition, investors should use it in conjunction with other investment metrics and analysis. Professional advice, especially for first-time buyers, is also a smart option.