Cap rate: which is better?

Question

All other things being equal, is it better to have a higher cap rate than a lower one? Is a 10% cap better than a 5%? And why?

Oleg Shalumov · Answer

@Derek Morrison higher cap is better when you are buying, as it means that comparing to the price you are paying the property would produce more cash flow to the owner.

When you are selling it is better to sell at the low cap. It would mean that you are getting more money for the property you are selling.

The formula for the cape Rate is the following:

Cap Rate = Net Operating Income / Price

Net Operating Income (NOI) is the sum of all potential income less vacancy and operating expenses. NOI does not consider debt payments, depreciation, or capital improvements.

Here is a very basic example:

You are buying a 10-unit apartment building which is offered for sale at $1 million. Its annualized rent roll is $100,000 with operating expenses totaling $40,000. What’s the Cap Rate ?

Capitalization Rate = ($100,000 – $40,000) / $1,000,000 = 5.5% Cap

Steve Vaughan · Answer

I strive to buy above the market cap for that asset type and class.

Without knowing the market cap, a 10 could be good or bad.  Same with a 6, 5, 3, etc.

I've purchased at a 14. Then a 12.  The market cap at the time was 10, then 9.  The off-market sellers didn't know what the market cap was.  Make sure you do.

The market cap for my 14 and 12 is now 7 and I'm considering selling. Def will if market gets to 6.  Know your exit points so you can  back into your entry points with a good market analysis.

Greg Scully · Answer

@Derek Morrison - Keep in mind that increasing the NOI on a lower cap rate means a larger increase in the value of the property.  If increase the NOI by 10k on a 10 CAP then the value increases by 100k.  The same increase on a 6 CAP is 166k.

Chase McArthur · Answer

@Derek Morrison

As everyone has previously stated, buy high, sell low.

In essence the cap rate is rough estimate of the return you would get if you bought the property with 100% equity (cash).

Typically, lower cap rates mean a more deairable, stabilized property which translates into a less riskier asset. I say typically because in today's market demand drastically outweighs supply. It is this demand that is compressing ( lowering) cap rates. Lower cap rates are typically found on Class A and B properties.

Higher cap rates are typically properties that require improvements, usually higher vacancy rates, are in less desirable areas and are usually Class C and below properties. Therefore the higher cap rate can translate into a more riskier investment.

This however doesnt apply to all property types. For example, mobile home parks are typically higher cap rates, which doesn't necessarily mean that the property is in disrepair. In most cases MHCs requires less maintenance and are less management intensive; they are just cash cows with very low turnover. The reason why these investments are usually command higher caps is because they are less desirable due to the fact they are less sexier of an asset to own. This however is rapidly changing in today's market.

Chris Grenzig · Answer

@Derek Morrison I actually think neither is better than the other. Yes you want to sell at a lower cap than you buy because instant value, but there is a reason people buy 3 and 4% cap rates in NYC.

Lower cap rates tend to be less risky investments because they are in high demand areas and, in theory, should have a much better ability to preserve capital

A higher cap rate are in areas of much lower demand or are seen as more risky in terms of interest from tenants; whether its apartments, office, industrial, etc

There's always going to be demand for apartments in NYC no matter what, just at what price

There may or may not be demand for apartments in a town of 10,000 people, which is why that may go for a way lower cap rate.

At the end of the day you have to have a strategy that you feel comfortable with, and weigh the risk vs the return on every investment.

Amy Heitner · Answer

As Oleg says, a higher cap rate is good for the buyer.

The reality today is that the growing desirability of multifamily means that cap rates continue to decrease, while prices are at an all-time high.

That's why even though there is still money to be made, you need every advantage you can get as a multifamily investor.

John M Chludzinski · Answer

Oleg:  In your simple example, I think you forgot to express that vacancy assumption of 5%? Thus the cap rate of 5.5% instead of 6% where your math showed?

Oleg Shalumov · Answer

Good catch John! wanted to keep it simple and removed the vacancy ... updated the post.

Jason D. · Answer

@Derek Morrison it's better to own a lower CAP rate, but get a higher rate of return than the current CAP rate.

Derek Morrison · Answer

@Oleg Shalumov thanks Oleg for the detailed answer!!

Cap rate: which is better?

Most Popular Reply