Are you familiar with cap rates and what they mean for a successful commercial investment?
Cap rates (short for capitalization rates) are one of the most quoted numbers in commercial real estate. But cap rates aren’t a magic number that tells you whether a deal is “good” or “bad.” They’re a snapshot and a starting point for deeper financial analyses. We’re talking about that today, calling upon our extensive experience as property management experts and investment partners to some of the most successful commercial investors in California. Here’s what we can tell you about navigating cap rates.
Quick Summary:
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What Cap Rates Can (and Cannot) Tell a Commercial Investor
At its simplest, the cap rate is the following formula:
`Cap rate = Net Operating Income (NOI) ÷ Purchase Price`
The NOI includes all property income (rent, parking, service fees) minus operating expenses (property management, insurance, utilities, repairs, excluding debt service and income taxes).
So here’s an example:
A property with a $200,000 NOI selling for $2,000,000 has a cap rate of 10% ($200k ÷ $2M = 0.10).
Makes sense, yes? Cap rates show the unlevered return an investor would get if they bought the asset in cash today, based solely on current income. They’re used to compare properties, estimate value, and create a baseline for more complex return metrics.
Cap rates are a useful shorthand, but they don’t capture:
Future income growth through rent increases, turnover, lease escalations, etc.
Capital expenditures (CapEx) or deferred maintenance
Financing impact which can dramatically change returns
Timing of cash flows (cap rates ignore the path of future NOI)
Market liquidity and exit risk how easy it is to sell later
Our advice? Use cap rate to compare, but never rely on it alone.
What Moves Cap Rates for Commercial Investments?
Understanding what affects cap rates helps investors read the market and price their risk correctly.
Interest rates and the cost of capital
When borrowing costs rise, buyers expect higher returns to compensate; cap rates typically move up. Conversely, lower rates compress cap rates.
Supply and demand for assets
Strong buyer demand for scarce product compresses cap rates. Good examples in California are industrial space in the Inland Empire or high-quality life science labs around the Bay Area
Property-level risk
Short lease terms, weak tenant credit, functional obsolescence such as outdated office floor plates, or high vacancy push cap rates higher.
Macro and local economic health
Job growth, population shifts, and industry concentration (tech in SF Peninsula, entertainment in LA) influence investor confidence.
Regulatory and legal risk
Zoning constraints, environmental liabilities, seismic retrofit requirements, or local rent/land-use policies can change perceived risk. California’s regulatory environment is uniquely complex, and investors need to factor that in.
CapEx and maintenance needs
A property with deferred maintenance or anticipated heavy CapEx will sell at a higher cap rate unless priced for repairs.
Let’s talk about some of California’s specific cap rate considerations. California markets are diverse, so it’s important for investors to consider micro-market variations. Coastal gateway cities like San Francisco, LA, and San Diego, have different demand drivers and risk profiles than markets such as Bakersfield and Fresno.
There’s also a unique climate and environmental risks. From wildfires to droughts, insurance costs and availability can be affected and so can capital needs. Factor potential insurance premium spikes and resiliency investments into any cap rate analysis.
Seismic safety and building codes are going to matter. Older buildings may require seismic retrofits; budget for those costs when estimating future NOI and value. There’s also zoning complexity. California’s planning processes can be long and unpredictable. Projects that require rezoning or conditional use permits may carry extra timeline and political risk.
Cap Rates Commercial Real Estate Investors Use
Here are some of the cap rates that commercial real estate investors in California are most likely to use.
Going-in cap rate. Based on current NOI and purchase price. Useful for initial comparison.
Stabilized cap rate. Adjusts NOI for a stabilized occupancy and normalized expenses. This is helpful for assets that need leasing or operational improvements.
Exit cap rate. The cap rate an investor expects when they sell. Often used in discounted cash flow (DCF) models; businesses plan for potential cap-rate compression or expansion at exit.
Market (or prevailing) cap rate. Average cap rate for comparable properties in a market. Use this as a sanity check, but always adjust for asset-specific differences.
How should investors think about cap rate spreads and risk premiums?
Investors often look at the spread between a cap rate and a risk-free benchmark (like a treasury yield) or the spread between cap rates of different property types. Wider spreads mean greater perceived risk or higher expected returns.
For example, an industrial asset with long-term, triple-net (NNN) leases to strong tenants will typically trade at a tighter cap (lower cap rate) than a small retail center with short leases and higher vacancy risk. Use spreads to quantify how much incremental return you demand for taking on extra risk.
Practical Steps to Using Cap Rates for Underwriting
Start with NOI accuracy. Ask for rent rolls, recent P & Ls, and leases. Adjust for non-recurring items, owner perks, or under-market rents. Use conservative assumptions.
Normalize expenses. Convert owner-paid utilities, discretionary repairs, or one-off insurance credits to a market-level expense profile.
Run sensitivity tests. Model NOI under several scenarios. See how small changes to vacancy, rental growth, or CapEx affect cap rate and returns.
Evaluate comparable sales. Look for recent transactions for similar assets in the same micro-market. Adjust for differences in tenant quality, lease terms, and physical condition.
Consider lease structure. NNN leases where tenants pay most expenses typically command tighter cap rates than full-service leases.
Account for CapEx and deferred maintenance. Convert expected capital projects into an annualized number in your underwriting (maybe a $300k seismic retrofit spread across a 10-year holding period).
Model exit assumptions explicitly. Your terminal cap rate has a big impact on IRR, so be conservative, especially in uncertain markets.
How Cap Rates Affect Financing and Returns
Cap rates influence the lender and equity math. A lower cap rate implies a higher purchase price for the same NOI, which reduces an investor’s debt coverage ratio and may limit loan terms. But on the other hand, higher cap rates may create attractive cash-on-cash returns but could indicate market distress.
Remember that leverage magnifies both gains and losses. Buying at a compressed cap rate when rates rise can lead to the erosion of property values fairly quickly. Stress-test your debt service under rising interest rates and falling NOI scenarios.
Negotiation and Value-add Strategies Tied to Cap Rates
If the market cap rate is low and an investor finds expensive pricing, it’s important to look for ways to create value. This will justify a lower perceived risk. Our ideas?
Improve tenancy. Sign longer-term leases with creditworthy tenants or secure lease escalations for extra stability.
Improve operational efficiencies. Reduce expenses through better property management, energy upgrades, or automation. Invest in new technology, for example.
Repositioning. Finding a new, better tenant is one way to do this. Also, repurposing underutilized spaces where zoning and demand allow can help.
Parking, signage, and ancillary income. Add revenue streams that lift NOI without large capital outlays.
When buying in a market with higher cap rates, there may be bargaining room, but it’s important to be comfortable with the higher income volatility and exit risk.
Risks and Red Flags
If a commercial real estate deal includes an overstated NOI or short-term leases that hide an approaching vacancy, a smart investor might pause before closing the deal. Look for large, unbudgeted CapEx needs such as a new roof, an aging HVAC system, or needed seismic upgrades. There shouldn’t be any environmental or title issues, and no buyer wants to see insurance gaps, especially in areas prone to wildfires or floods where insurers may add exclusions or hike premiums.
Don’t let a superficially attractive cap rate lure you into ignoring these fundamentals.
When navigating cap rates, we recommend that you treat them less like a grade and more like a compass. They point you in the right direction. Your job as an investor is to take a closer look and poke around a little bit more.
Let’s talk about the cap rates that may be causing you to scratch your head. Contact our expert property management team at Bell Properties Commercial Real Estate.
