CAP Rate high/low question?

Question

So I get why people use cap rats and how to calculate them.

But why is high cap rate good for seller and low cap rate better for buyer? I don't get the reasoning behind it?

Everett Fujii · Answer

@Andrew Johnson

Your reasoning could be one way to look at it, but not the most common or standard method.

Cap rate is nothing more than another way to value a property.  A low cap rate doesn't necessarily mean an under performing property anymore than a high cap rate is indicative of a property with little to no upside.

Remember, cap rate is nothing more than the cash on cash return if the property were to be purchased for all cash.

Asset class (A, B, C, D) and, as you mentioned, location plays an enormous factor here.

In general, the cap rate is primarily indicating the risk of the asset.

It can also be used as a quick guideline when determining which deal to focus on.  If you get a number of deals to underwrite you would focus on those with higher cap rates (if buying) first as those are the ones that supposedly offer the best return.  Of course that's an oversimplification of what happens as there are an enormous number of factors that also go into whether a 4 cap investment is worth spending time on or not.

To put it another way, the lower the cap rate the less margin of error in both income and expenses you can absorb before the property turns negative.  So A class properties with high/stable income tenants who are theoretically less likely to default on their rental payments are considered safer.  Therefore A class properties sell for a lower cap rate.  The other side of the coin are D class properties with people to live pay check to pay check (and more often than not with government assistance) and are liable to miss their rental payments and require eviction in any given month.  That is why D class properties require a high cap rate.  They have higher risk, so the return must compensate for that risk.

Jonathan Twombly · Answer

@Peter Kim  It's the other way around.  Low cap rate = high price relative to NOI, so good for the seller.  High cap rate = low price relative to NOI, so good for the buyer.

Everett Fujii · Answer

@Peter Kim

As has been mentioned you have the low/high cap rate and who it benefits backwards.

It's an inverse relationship.

A high cap rate is good for the buyer because they get a good return on their money.

A low cap rate is good for the seller because they get a higher sales price relative to the NOI of the property.

To use some numbers to illustrate the relationship.

Let's say a property has an NOI of $100k.

At a 10 cap, that property is worth $1M; 100k/1M= 10%

At a 5 cap, that property is worth $2M; 100k/2M= 5%

So from the buyers perspective they obviously want the higher cap rate, just as the seller wants the lower cap rate.

Russell Brazil · Answer

Cap rates are only a snap shot in time.  A low cap rate can also be indicative of a property in a high rent growth area.  A low cap rate can also be indicative of the market viewing the asset as low risk. A high cap rate can be indicative of a the market viewing the property as high risk.

Thomas S. · Answer

Other way around but bottom line is it determines value of income.

A high cap rate indicates high rent to purchase price ratio.

High cap = higher profit margins.

Peter K. · Answer

Gotcha. Great explanations. Greatly appreciate it.

Travis Dawson · Answer

The only way I could see a low cap rate being good for the buyer is if it indicates that the property is currently renting out at far lower than the market rate and the buyer knows it.But that assumes you could use the low cap rate to negotiate a more favorable deal than asking price.

CAP Rate high/low question?

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