What Is Cap Rate Spread?

Cap rate spread indicates the level of real estate risk a commercial investment may induce. You can find it with a simple calculation: the difference between the property’s capitalization rate and the current 10-Year Treasury Rate. 

U.S. Treasury investments – such as bonds – are considered risk-free. When used with a commercial property’s cap rate, you can quickly deduce a given investment’s potential level of risk. This added risk is often referred to as the real estate risk premium. 

For commercial investors, the risk premium is considered to be compensation for holding an asset riskier than a 10-Year Treasury bond. It’s essentially the excess in your earnings if you were to invest in commercial real estate vs. a risk-free asset.

Cap Rate Spread vs. Cap Rate

Before you can calculate cap rate spread, you have to understand how capitalization rates (or cap rates) work. 

The cap rate spread of your investment opportunities indicates the amount of risk you’d be adding to your portfolio from buying commercial property. Whereas the cap rate of a property tells you more about the potential return on investment of the property. 

Both calculations help investors make sound investment decisions by indicating both risk and return.

First Things First: How To Calculate Cap Rate 

Calculating the cap rate spread for a multifamily housing property – or any other commercial property – starts by knowing how to calculate the cap rate. Using the capitalization rate instead of a simple ROI formula will give you a better picture of the property’s profitability, regardless of the financing methods and other nuances. 

To find the cap rate, divide annual net operating costs (NOI) by the property’s value. To convert this into a percentage, multiply the number from the previous equation by 100. Simply put: 

Cap Rate = (Net Operating Income / Property Value) x 100

For a more concrete example, let’s say the annual NOI of a property is $50,000, and said property is valued at $800,000. 

Cap Rate = ($50,000 / $800,000) x 100 = 6.25%

The cap rate for this commercial property is 6.25%. Traditionally, the higher the cap rate, the greater the risk you take on.

How To Calculate Cap Rate Spread

Calculating cap rate spread is simple once you know your target property’s cap rate and the current treasury yield. Let’s assume the 10-Year Treasury Rate is 4.6%. Using the previous example where we calculated our cap rate (6.25%), we can now decipher our cap rate spread. 

Cap Rate Spread = Cap Rate (%) – 10-Year Treasury Rate (%) 

Above you’ll find an equation that will help you know how to calculate cap rate spread, and below you’ll see a concrete example. 

Cap Rate Spread = 6.25% – 4.6% = 1.65%

A cap rate spread of 1.65% is roughly average – but this also depends on the types of commercial property you’re evaluating. Traditionally, a high spread indicates a high degree of risk, while a low spread implies a lower level of risk. 

Another method for calculating cap rate spread is to swap out the 10-Year Treasury Rate with BBB bond rates. This can be slightly less accurate, however, as BBB bonds still carry a certain level of risk. 

However, utilizing BBB bond rates can be useful in comparing average cap rate spreads across commercial sectors. Industrial, multifamily, office, and retail buildings all have different cap rate spread averages. 

Historically, the average cap rate spread is 2.50% for industrial property, 1.50% for multifamily property, 2.40% for office property, and 2.30% for retail property. But keep in mind that these averages are based on cap rate spreads calculated with BBB bond rates, rather than the 10-Year Treasury Rate.

Why Does Cap Rate Spread Matter in Commercial Real Estate? 

As a real estate investor, understanding every aspect of an investment is crucial to successfully advancing your portfolio. This includes everything from the potential risks of investing in the property, to how you’ll be taxed on any gains from the investment later on. Calculating cap rate spread is one of the quickest ways to evaluate the aforementioned risk and ensure your next venture won’t fall flat. 

Aside from cap rate spread, it’s important to use other calculations in evaluating the potential profitability of an investment. These metrics include: 

• Return on Investment: Property’s equity / total costs
• 50% Rule: The idea of this rule is to collect enough rent to put 50% towards operating expenses. Estimated monthly operating expenses = property’s gross rent x 50%
• Cash on Cash Returns: Annual before tax cash-flow / total invested
• Gross Rent Multiplier: Property value / gross rental income

Each of the listed metrics and calculations can give you a clearer picture of an investment opportunity’s potential. 

Cap Rate Spread Questions and Considerations

Cap rate spread is a simple concept, but there are still additional things to consider. If you have further questions, they’re likely covered in the frequently asked questions below. 

What does spread mean in commercial real estate? The term “spread” in commercial real estate can refer to a few different concepts. One, as described in this article, is cap rate spread which evaluates the potential risk of an investment property. 

The second spread is a development spread which evaluates how financially viable a development project would be. Finally, the commercial mortgage-backed security (CMBS) spread impacts real estate financing. 

How can I use cap rate spread to evaluate the ROI of a property? Cap rate spread is used to indicate the perceived risk of a property, and can do little to inform you of the ROI. To identify the ROI, you’ll instead want to use the capitalization rate calculation. 

What influences cap rate spread? Like most things, the real estate market acts in a cyclical pattern. If you can identify the phase of the pattern it’s currently in, it will be far easier to make sound investment decisions. Similarly, understanding the specific factors that influence cap rate spread can also help you identify current market phases, and vice versa.

• Property Condition: Lower quality properties (such as Class C or D) have a higher degree of risk, while Class A properties are often much less risky. 
• Loan-to-Value: The higher the LTV, the higher the spread since such financing terms increase risk for lenders. You may find that some lender requirements for LTV are up to 80%, but this is typically only the case for less risky properties. 
• Tenant Strength: High-profile corporations acting as tenants in a commercial building with a long-term lease is significantly less risky than lesser-known tenants would be, and would thus reduce cap rate spreads. 
• Cash Flow: The more cash flow, the less risk a property will be. Increasing a property’s cash flow can aid in minimizing its cap rate spread. 
• Loan Term and Size: The risk posed by long-term commercial building loans often leads to a higher cap rate spread, while a short-term commercial building loan (even if it’s for a larger sum of money) is often less risky. 

Having a successful investment depends greatly on how well you do your research before committing any money. Using cap rate spread to measure risk is just one of the crucial metrics that can help you gauge the profitability of a property. 

If you’ve already done your due diligence and are ready to partner with a trusted private lending organization, contact Revolution Realty Capital today to learn more about our small-balance commercial loans. 

Alternatively, if purchasing physical property is starting to sound like too much work for your busy schedule, consider investing in a lucrative private real estate fund instead.