Santa Monica, CA · Member since 2017 · 24 posts · 3 votes
I am a little unclear if a larger or smaller is better. When and how often should I use it, how to find rate not the % but actual rate. IE; 6.5%, 7.0% etc. Thank you
Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes
7y
@Andy Morris your question is more complex than it seems. A higher cap rate means more cash flow (specifically net operating income) for a given price. A lower cap rate means less cash flow for a given price.
On the surface you would think that a higher cap rate is good. Maybe, maybe not. If a property is getting good market exposure it is going to sell for close to the market cap rate. If the marketplace is saying that the cap rate is high on a property, it is because the market views it as a risky property. Therefore the market wants more return for that risk. If the marketplace views a property as low risk it is willing to pay a premium price ( and therefore a low return) for that property.
EX; Property generates $50,000 a year (NOI)
If the property sells for $500,000 that is a 10% cap rate. The market is saying that is a relatively risky property
If the property sells for $1,250,000 that is a 4% cap rate and the marketplace is saying it believes that to be a pretty safe investment.
Specialist · Riverside, CA · Member since 2015 · 6k+ posts · 3k+ votes
7y
For cap rate higher is better it is basically the return on your money. Cap rate is income - annual expenses excluding interest and depreciation divided by purchase price.
Investor · Baltimore, MD · Member since 2008 · 17k+ posts · 13k+ votes
7y
@Andy Morris your question is more complex than it seems. A higher cap rate means more cash flow (specifically net operating income) for a given price. A lower cap rate means less cash flow for a given price.
On the surface you would think that a higher cap rate is good. Maybe, maybe not. If a property is getting good market exposure it is going to sell for close to the market cap rate. If the marketplace is saying that the cap rate is high on a property, it is because the market views it as a risky property. Therefore the market wants more return for that risk. If the marketplace views a property as low risk it is willing to pay a premium price ( and therefore a low return) for that property.
EX; Property generates $50,000 a year (NOI)
If the property sells for $500,000 that is a 10% cap rate. The market is saying that is a relatively risky property
If the property sells for $1,250,000 that is a 4% cap rate and the marketplace is saying it believes that to be a pretty safe investment.
Investor · Tempe, AZ · Member since 2018 · 1k+ posts · 731 votes
7y
Hi @Andy Morris. It depends what you are trying to do.
If you're buying single-family rental (SFR), don't even worry about it. Stick to ROI. Don't over complicate this.
CapRates are mostly used in commercial real estate (CRE). Unlike SFR, commercial assets are valued based off of your net operating income (NOI) and Cap Rate.
How to Value CRE: NOI / CapRate. For example, $100,000 / 10% = $1,000,000 valuation.
Why We Value CapRate: CapRate is the negotiation term because your NOI is what it is. Unlike residential, commercial assets aren't based off of comparable prices. 2 office buildings next to one another can have dramatically different valuations because one is twice as big. However, if they're similar in class of tenants, location, and rent rates then you can use the CapRate as an essential "comparable".
Assets Types: Every class of assets have different Caps. You might see office at 10%, mutlifamily 8% and industrial at 6% all in the same metropolitan area. So you can't compare Cap Rates across asset classes.
Regional: Real estate is very local based, you need to know your local CapRate comps. As a former CRE developer for industrial assets, you would see rates varies across markets: LA 3-4%, Inland Empire 5-6%, Phoenix 7-8%, Bay Area 4-5%.
To answer your question, do you want a high or low cap?
Cap Rates are opposite mindset of traditional investments: Buy high, sell low!
Consider this scenario: you buy an investment that has a NOI of $50,000 at a 10% cap. $500,000 purchase. Then you decide to sell it.
Rents remained at $50k NOI, sell at a 9% cap: $555,555 valuation
Raised rents to $100k NOI, sell at same 10% cap: $1,000,000 valuation.
Raised rents to $100k NOI, sell at a 9% cap: $1,111,111 valuation
Investor · Tempe, AZ · Member since 2018 · 1k+ posts · 731 votes
7y
@Andy Morris, MF can definitely benefit from understanding and negotiating the CapRate. Although it is small enough units that often people still use comps in the area for pricing.
Real Estate Broker · St. Louis, MO · Member since 2018 · 101 posts · 85 votes
7y
As stated above, cap rates are basically risk factors. In St. Louis, on one street I wouldn't buy under a 10 cap. 4 blocks over I would justify a 6.5 cap purchase. It's all determined by the numbers, but above that the tenant base, type of property, comps, location, etc, that determine the value of the property.
Compare cap rates to stocks. You pay a premium for a stock of Amazon, which won't get you a super high return, but is relatively safe. Or, you could dump that large sum into a bunch of cheaper stocks and have the potential for a much larger return, but it is a much riskier investment. It all comes down to your tolerance to risk and ultimately what you are wanting out of a property: Cash flow, appreciation, least amount of involvement vs. high involvement, safe haven for funds, etc.