In short, a CAP rate on a commercial property is simply a way for investors, lenders, and other real estate professionals to quickly see the strength of the subject property and the likely one year unleveraged (meaning the property is purchased with cash) return that the property may generate. Like any other investment, investors need a way to compare one property with another and have a way to measure which is the stronger (less risky) investment – or vice versa, if they are willing to take on more risk, for more potential return; the CAP rate is that measurement.
The lower the CAP rate, the stronger (and more expensive) the property is. In a major market, think San Francisco or LA, you can expect to see CAP rates in the 4%-5% range. CAP rates can be in the higher single digits in a tertiary market and increase into double digits. In the most basic terms, an investor looking at a building with a 4% CAP should expect that building to yield approximately 4% in one year. An 8% CAP will be a property with a higher risk profile, hence the higher potential return required by sponsors (8%).
The CAP rate is usually always published on real estate presentations or websites, though it can be easily calculated. Take the Net Operating Income (NOI) of the property and divide it by the current market value as per current market prevailing rates.
CAP rates should be used as a quick basis for measurement to compare properties but not fully base a decision on. The reason for this is that CAP rates fluctuate based on the calculated NOI of the property, which can change based on the year, location, expenses for the building, etc. The CAP rate can also be adjusted based on who the intended reader of the information is. In summary, the CAP rate should be used as a quick measurement of a properties’ strength. If the estimated returns fit your investment profile, you should dig deeper into the property's details.