When it comes to investing in commercial real estate (CRE), understanding key financial metrics is essential. Two of the most commonly discussed metrics are the capitalization rate (cap rate) and yield. These figures provide insight into the potential return on investment and the risk involved in a property, but they measure different aspects. Let’s explore what these metrics are, how they’re calculated, and how they differ.

What is the Capitalization Rate (Cap Rate)?

The cap rate is a financial metric used to evaluate the potential return on a real estate investment. It reflects the relationship between a property’s net operating income (NOI) and its market value. In essence, the cap rate shows how much income an investor can expect to generate annually relative to the property’s value.

Cap Rate Formula:
Cap Rate = Net Operating Income / Property Value

For example, if a property generates an NOI of $100,000 and has a market value of $1,000,000, the cap rate is 10%. This gives investors a sense of how much return they can expect if they buy the property outright.

What is Yield?

Yield, on the other hand, measures the return on an investment based on the amount paid for the property. It calculates the income generated from the property relative to its purchase price (total cost). Yield can be classified as either levered (with debt financing) or unlevered (without debt financing).

Yield Formula:
Yield = Annual Income / Total Cost

For a more detailed calculation:

• Unlevered Yield: Net Operating Income / Total Cost
• Levered Yield: Cash Flow After Debt Service / Down Payment

In most cases, levered yield is higher than unlevered yield because of the reduced upfront capital required when debt financing is involved.

Key Differences Between Cap Rate and Yield

The fundamental distinction between cap rate and yield lies in the denominator. Cap rate uses the current market value of the property, which fluctuates over time, while yield is based on the total cost (which is typically fixed once the property is purchased).

At the time of purchase, these two metrics may align closely, but as the property’s value changes, their difference becomes more apparent. For instance, as property values rise, cap rates tend to decrease, leading to a potential reduction in yield if the purchase price stays constant.

How Do Cap Rate and Yield Relate?

Both cap rate and yield provide a snapshot of potential return, but they differ in how they treat the property’s price. Rising property values typically cause the cap rate to fall. If a property produces the same income but its value increases, the cap rate will decrease, which in turn can result in a lower yield if the total cost increases proportionally.

Example of Cap Rate vs. Yield

To better understand how these metrics work in practice, let’s consider an example:

• Purchase Price: $5,000,000
• Market Value: $5,250,000
• Net Operating Income: $400,000
• Cash Flow After Debt Service: $200,000
• Down Payment: $1,000,000

Cap Rate Calculation:
$400,000 / $5,250,000 = 7.61%

Unlevered Yield Calculation:
$400,000 / $5,000,000 = 8.00%

Levered Yield Calculation:
$200,000 / $1,000,000 = 20.00%

In this scenario, there’s a noticeable difference between the cap rate, unlevered yield, and levered yield. The cap rate is 7.61%, unlevered yield is 8%, and with leverage, the yield jumps to 20%.

What is a Good Cap Rate and Yield?

Determining what constitutes a “good” cap rate or yield is subjective and varies based on the type of property, its location, and the investor’s expectations. Generally, cap rates in commercial real estate range from 4% to 10%, but this can vary greatly depending on factors such as market conditions and property type.

For yield, a range of 8% to 15% is typically seen as good, but again, this depends on the investor’s personal return requirements. If an investor is aiming for a 20% return, a yield of 15% might not be sufficient.

Conclusion

The cap rate and yield are both crucial metrics for real estate investors, but they measure different aspects of potential returns. Cap rate evaluates the return based on property value, while yield looks at the return relative to the purchase cost. Both metrics offer valuable insights into the financial performance of a property, but understanding their differences helps investors make more informed decisions. Whether you’re considering a property’s market value or analyzing how debt affects your return, knowing how to calculate and interpret these metrics is key to successful real estate investing.