CAP rates like I’m five

13 Replies

So as I understand, a CAP rate is based on NOI. However, I’ve also been told that CAP rates have to do with risk. Question, why would I want a higher CAP rate if it brings increased risk. For example taking a 6 CAP to a 9 CAP. Thanks for the help!!!!

I don't really see a question here. But yes you can expect 5 caps to be in nicer areas with newer more stable buildings with higher rents/unit. While 12 caps are older with worse neighborhoods with lower average rents/unit.

Same with life. People need to get paid more to put up with crap and have more potential losses. Starting a new business could be big money or a big loss. Buying the S&P index fund is safer with no big upside.

Hey @Nick Mauldin ! CAP rate is a bench mark for judging dissimilar properties, and for telling you how well its performing based on the cost of the property. The higher rate doesn't relate to risk necessarily but can help get you in the ball park on if you want to analyse a property further. CAP rate is short for capitalization rate, meaning how long till you pay off the asset cost with the net income. So lets say for easy numbers...I have a two unit property that would cost me 100K that is making me a net income of 10K a year and a 3 unit that was 200K and was making me 16K a year.

1.) 10,000/100,000 -> .10 -> 10% cap rate, or ten years to capitalize on my investment. 

2.) 16,000/200,000 -> .08 -> 8% cap rate, 12.5 years to capitalize on my investment. 

So though the two options are a lot different I can quickly see that the first option is a better cap rate even though its less cash flow. At this point it really depends on what your investment strategy is. Some people don't care about cap rate and want to look at the cash flow per door, or cash on cash return. But its still a good tool for at least giving you a 30,000 view to get you in the ball park on if this is something you want to look at. You can also use this to see what is normal for your area on what is a good deal or not. I know in some places they wont touch something unless its a 10% cap rate, in other areas they would jump at 6%. Any folks want to jump in on that part of the discussion? 

Good luck Nick! 

JB. 

If you're a buyer, you want a higher cap rate for the risk you take. A higher cap rate for a buyer means you get the property for cheaper relative to the rents you collect. As a seller, you want a low cap rate because that means you can sell for higher relative to the rents you collect.

Thats a good way to describe it too Account Closed  but from a marketing standpoint its going to be hard to get someone to buy your property if you don't show a good cap rate compared to other properties in your market. 

There may or may not be a correlation between cap rate and risk.  Here is an example. Is a 4 cap in LA less risky than a 6 cap in Dallas?  If you bought a property at a 1cap because of high vacancy, I wouldn't call this a low risk transaction.  The point is, typically a high cap rate may indicate that the property is in a bad area, but a low cap rate doesn't mean that it is a lower risk property.

CAP rate is the rate investors will accept in the market. A 5% cap takes 20 years to recapitalize, or get your money back. Has nothing to do with NOI.

Valuation has to do with applying the market cap rate to the NOI. Divide the NOI by the cap rate to value commercial assets.

In my markets, market caps are 6.5 and 7.5.  When they compress to 5.5 and 6.5, I'm outtie and investing elsewhere!  I bought at 9 and 14.

@Jeff Greenberg Thank you so much for your time. While I currently live overseas, I will be looking to move back to the Pacific Northwest here shortly. Most of the CAP rates I'm seeing are at 6. I'm just trying to get a handle on how to use the CAP rate to value a property. Again thank you for your time.

@Justin Brown Thank you for the response and your time. I really like your example it gives me something to sink my teeth into. I also have a better understanding of the different strategies that I may be interested in. Another question then: If I'm only worried about cash flow, does the CAP rate really matter to me? The second example you provided is only a CAP rate of 8 but it brings in an extra 16K a year. In my opinion I'm much more interested in that. I can (hopefully) find ways to make the product more valuable over time. Thanks again for your time!!!

Its all about the money right!  I think you're exactly right, who cares what the cap rate is if its making you the money you want. Cash flow, and cash on cash return I think are much better metrics. As a realtor I see people all the time like to inflate the cap rate anyway so I ignore it and just move to calculating the expenses and what it ends up cash flowing. 

Originally posted by @Nick Mauldin :

@Steve Vaughan why would you be out at 5.5 to 6.5 CAP rate? Thanks for the response and giving me some of your time.

 Oh just a valuation target I've had for a long time.  When value is close to replacement cost (think insurance coverage), I always exit if possible.  

Others can let their chips ride if they want to, or buy and be ok with a 5% return, but I can beat that passively elsewhere with things that don't need maintenance or call me on weekends.  Cheers!

In a market there are many things that drive Cap rates. 

1. Location - if everyone wants to buy, then cap rate goes down and price goes up. Supply and demand

2. Condition - If it's in excellent condition, then it will sell for lower cap (at least based on a pro forma)

3. Trends - Cool stuff going on in the area, then more buyers, lower caps

4. Interest rates - low interest rates, low caps

5. Jobs - More jobs, lower cap

6. Population growth- more density, lower caps

7. Crime - High crime, high caps

8. Age - Newer means lower cap rate

Many more things will affect the cap rates, but basically think of it as the newer and more attractive the property and location the lower then cap.