Updated 1/3/2022 –
How do you analyze rental properties? In other articles, I showed how to run the numbers with back-of-the-envelope analysis, including the super-simple one percent rule. But the most well-known rental analysis tool I use is something called a cap rate.
In this article, I’ll explain what a cap rate (aka a capitalization rate) is. I’ll also share examples of how to use the cap rate formula in a very practical way to analyze real estate markets and rental properties.
With the cap rate as a tool in your rental property toolbox, you’ll be able to more confidently buy and profit from your own investment properties.
What Is a Cap Rate?
A cap rate is simply a formula. It’s the ratio of a rental property’s net operating income to its purchase price (including any upfront repairs):
Cap Rate =
Net Operating Income (NOI) ÷ Purchase Price |
The formula can be used on the level of an individual property by looking at its net operating income compared to its value. But it can also be used on the level of an entire market by taking average cap rates for a large group of properties.
Importantly, the cap rate formula does NOT include any mortgage expenses. As you can see in the formula for net operating income below, the expenses do not include a mortgage or interest payment.
Excluding debt is part of why a cap rate is so useful. The formula is focused on the property alone and not the financing used to buy the property.
Every investor uses a different combination of down payment and financing. So, a cap rate assumes a property is bought for cash without leverage.
This assumption lets you focus on the merits of the property’s financials instead of being distracted by debt. It also lets you compare the risk of one property or market to another.
Watch Me Explain Cap Rate on YouTube
How to Measure Risk
Beyond a simple math formula, a cap rate is best understood as a measure of risk. So in theory, a higher cap rate means an investment is more risky. A lower cap rate means an investment is less risky.
It’s the same principle that gives you a lower return for low-risk assets like Treasury bonds (1.91% for 30-year bonds as of 8/27/21) than for more risky assets like stocks (average annual historical returns close to 10%).
What does it mean to be more risky?
Risk is what Warren Buffett talks about in his #1 rule of investing – “don’t lose money.” As an investor, you can’t just pay attention to returns or profit. You also have to estimate and protect yourself against the possibility of losing money.
So, to better judge risk for your real estate investment purchases, you can start with three major factors that affect cap rates.
3 Major Factors That Affect Cap Rates
Like taking the temperature of the air, a cap rate is just a way of measuring actual investment activity in the real world. And just like geography and weather patterns affect temperature, there are three major factors that affect cap rates:
- Macro-level economics and demographics
- Micro-level market influences
- The type of property
These three factors combine to give each individual property or local market its unique cap rate. Let’s take a look at each one so that you can understand them better.
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How Macro-Level Economics and Demographics Affect Cap Rate
Let’s say you buy a property in a major metropolitan area like San Francisco. It’s a big city with a strong, diverse economy. It also has high demand from a constant influx of real estate renters and buyers .
At the same time, San Francisco has a lack of new construction supply because of land shortage and regulatory restrictions.
So as I explained in How to Pick the Ideal Location For Investment Properties, these macro-level economic and demographic factors positively affect real estate values. And that generally makes the real estate in a place like San Francisco less risky for investors to invest their money.
In terms of cap rates, this means San Francisco has low cap rates (i.e. high prices). And practically, this means investors and property owners there are willing to accept lower-income returns because of the lower perceived risk.
On the other hand, the economic and demographic fundamentals of a rural or small town market are different. These locations are economically not as strong as a growing, big city that has a diversified economy. So, investors here demand higher cap rates to compensate for this risk.
Using data from real estate firm CBRE’s U.S. Cap Rate Survey for Qtr 3, 2020, this chart shows the difference in cap rates between markets. The cap rates are for stabilized, infill (i.e. urban), class A apartment buildings in each location.
Cap Rates For Stabilized, Class A Multifamily Apartments By City – 2020 (Qtr 3) | |
Austin, TX | 4.25% |
San Francisco | 4.25% |
San Diego | 4.50% |
Chicago | 4.50% |
Atlanta | 4.50% |
Washington D.C. | 5.00% |
Philadelphia | 5.25% |
New York City | 5.75% |
But cap rates don’t just help you compare different markets. They also help you compare different locations and properties within a market (i.e. micro-level).
How Micro-Level (i.e. Local) Markets Affect Cap Rate
Some micro-level locations within the same market are better than others. To reflect this, commercial real estate buildings are organized into three classes (A, B, and C) based on their location and building condition. I add an extra “D” rating in my article that explains how this informal rating system works, Where to Buy an Investment Property – the A-B-C-D Rating System.
For now, just keep in mind that Class A means the newest, best located, and more in-demand buildings. And B, C, D get progressively older and less desirable. And investors in each class of property demand different cap rates.
Using the cap rate data from CBRE’s more detailed 2017 report, here are average cap rates for class A, B, and C properties within various cities around the U.S.
Cap Rates For Stabilized Multifamily Apartments By Property Type A, B, C – 2017 (2nd Half) | |||
City | A Class | B Class | C Class |
San Diego | 4.25% | 5.00% | 5.25% |
Chicago | 4.75% | 5.00% | 6.25% |
Atlanta | 5.00% | 5.50% | 6.50% |
Philadelphia | 5.25% | 6.00% | 6.75% |
St. Louis | 5.75% | 6.75% | 8.50% |
Cleveland | 6.25% | 7.00% | 9.00% |
Pittsburgh | 6.50% | 7.00% | 8.00% |
Detroit | 7.25% | 7.75% | 10.50% |
As you can see, the cap rates increase as you move to lower property classes. This doesn’t mean you shouldn’t invest in Class C or even Class D (I certainly have). It just means you need to understand the risks and figure out how to address them (which I’ll talk about in a later section).
But for now, there is one more factor that affects cap rates. It’s the type of property. I’ll explain with another example.
How Property Type Affects Cap Rate
Let’s say you buy a small residential apartment building in suburban Atlanta, Georgia. The market cap rate for your apartment building will typically be less than the cap rate for a small retail (i.e. store) shopping center in the exact same location.
Why the difference between residential and retail? Again, it’s risk.
During a recession (or the Coronavirus pandemic!), people will still need to live somewhere. So, an apartment building will likely stay full, even if rent rates are a little lower.
But a flower shop renting the retail location might go out of business during a recession. Office spaces during the Coronavirus pandemic sat empty. And that means the owner of a retail or office building could face long vacancies and much lower rents.
You can again see this difference in cap rates between property types using the CBRE U.S. Cap Rate Survey for Qtr 3, 2020. Here are the average cap rates by property type in the city of Charlotte, NC for that time period.
Charlotte, NC Cap Rates by Asset Class – 2020 (Qtr 3) | |
Multifamily (infill) | 4.75% |
Industrial | 5.25% |
Multifamily (suburban) | 5.50% |
Retail | 5.75% |
Office (Core Business District) | 7.25% |
Currently single family houses aren’t included in commercial real estate reports like these. But if there were to be cap rates for investor-owned single-family, my experience is that they are even lower risk (i.e. lower cap rates) than multifamily.
So, all three of these factors – macro, micro, and property type affect the cap rate of any particular building. Now let’s look at how you can use cap rates as a tool to analyze and buy better real estate deals.
How to Use Cap Rates as a Rental Property Investor
So far the idea of a cap rate may seem academic. It’s just a number in a report that measures an abstract concept like risk.
But in reality, a cap rate is a very practical tool. As a rental property investor, you can use it to:
- Pick a market, submarket, or property type to invest in
- Set goals and perform analysis for property acquisitions
- Decide to sell an existing property
In other words, a cap rate helps you make good decisions. And good decisions lead to you accomplishing your overall real estate and financial goals.
I’ll share an example in order to explain how you can use cap rates with your investment decisions.
Example of Analyzing Two Different Properties With Cap Rates
Let’s say you decide to buy a small apartment building. You and a business partner have saved a chunk of cash, and you plan to use that as a down payment. You’ll finance the balance of your purchase price with a mortgage loan.
Your local real estate agent uses the normal sources to look for properties, including the MLS (multiple listing service), Loopnet.com, and networking.
After a couple of weeks of searching, she presents you with two different acquisition opportunities.
Property #1 – Stable Income Producer at 6.48% Cap Rate
Property #1 is a 10-unit building available for a price of $1,000,000. Your agent considers it a class B property. It’s fully rented, needs no major repairs, and has a good management company in place. The location also has good long-term prospects for population and economic growth.
Here are the numbers:
- $9,000 = total monthly rent ($900/unit)
- -$3,600 = monthly operating expenses
- $5,400 = net operating income per month
- $64,800 = net operating income per year (5,400 x 12 months)
- 6.48% cap rate ($64,800 ÷ $1,000,000)
You like this deal because it produces stable income and has good long-term prospects. It also doesn’t have any major “gotchas” or moving parts. You can just buy it and immediately start collecting income using a 3rd party manager.
Now your agent presents you with Property #2.
Property #2 – 6.35% Cap Rate But an Opportunity to Add Value
Property #2 is a 15-unit building available for a price of $850,000. Your agent considers it a C class property, but the location is up-and-coming with B and even A-class properties nearby. Other investors are remodeling properties and raising rents. So, there is an opportunity to add value and potentially make a better return.
Here are the purchase numbers:
- $7,500 = total monthly rent ($500/unit)
- -$3,000 = monthly operating expenses
- $4,500 = net operating income per month
- $54,000 = net operating income per year ($4,500 x 12 months)
- 6.35% cap rate ($54,000 ÷ $850,000)
But remember there is an opportunity to add value and improve the financial picture. Your agent and your property manager are very confident that you can spend $150,000 ($10,000/unit) and increase the rent from $500 to $700/month for each unit.
Here are the new numbers after this improvement:
- $10,500 = total monthly rent ($700/unit)
- -$3,500 = monthly operating expenses
- $7,000 = net operating income per month
- $84,000 = net operating income per year ($7,000 x 12 months)
- Two options:
- Resell for $1,400,000 = new value if you sell at a 6% exit cap rate ($84,000 ÷ 6% = $1,400,00 )
- $400,000 gross net increase in value ($1,400,000 – $1,000,000)
- OR continue to rent for an 8.40% cap rate ($84,000 ÷ $1,000,000), more accurately called an unleveraged rental yield
- Resell for $1,400,000 = new value if you sell at a 6% exit cap rate ($84,000 ÷ 6% = $1,400,00 )
This second scenario will take more coordination. There is also the risk that the plan won’t work. The local or national economy could have problems before you finish. Or you might not execute the repairs or rent raises well enough.
But if you can address those risks and make the effort, the reward on the back-end is much better. For the same $1 million investment, you get a large increase in value and a much higher rate of return from income.
What’s a Good Cap Rate For Rental Properties?
Which property would you buy? Property #1 with the stable 6.35% cap rate? Or Property #2 with the more risky but more profitable potential 8.40% cap rate?
With investment decisions, there are no clear-cut answers.
A “good” cap rate will depend on your personal investment criteria and preferences.
Property #1 in the prior example could be a good fit for investors looking for a more stable, passive experience. And because of its solid location and positive future outlook, the numbers could get even better with time.
Property #2 could be a good fit for the more entrepreneurial investors. The potential returns are bigger if everything goes well. But there is also potential for lower returns or even losses.
I certainly fall into the entrepreneurial investor camp. In fact, I bought a very similar deal to Property #2 just a couple of years ago. It turned out very well.
But I can also imagine scenarios as I have more capital where investing in Property #1 could make sense.
What’s Your Outlook For the Future?
A “good” cap rate also depends on your outlook for the future of a property and location.
For example, let’s say you feel confident that the prices and rent for a property in nice location in San Diego, California will continue to grow for years to come. As a result, you may choose to accept a cap rate of 4% to 5% today even though the interest rate on your mortgage costs about the same amount!
You can probably guess my opinion about this strategy. I don’t like placing bets on an investment strategy that depends on speculation to succeed. It may be smart speculation. But the amount and timing of growth are still just educated guesses.
Instead, I like to choose markets and properties with reasonable current cap rates AND good long-term prospects. I’ve been fortunate to have this type of market where I live in the upstate of South Carolina. But if I didn’t, I would invest at a distance somewhere else.
After all, the income from these properties is what we aspiring early retirees use to build wealth and reach financial independence. By accepting cap rates so low that you produce no income today, your growth (and your path to financial independence) depends 100% on outside forces. That doesn’t leave me feeling warm and fuzzy inside.
Before we finish the topic of cap rates, there is one more factor to consider – interest rates. It’s something you have little control over, but it can affect both cap rates and your overall investing strategy.
How Interest Rates Affect Cap Rates
I’m sure you’ve noticed news about interest rate changes from the Federal Reserve. This rate is technically called the federal funds target rate, and it’s important because it can affect other rates throughout the economy, including cap rates.
Factors like local market economics, demographics, and other micro-level criteria affect cap rates the most. As I’ve explained, they matter because they’re the core fundamentals of real estate.
But because real estate values depend heavily on debt financing and national capital markets, interest rates also play a large role. So, changes in interest rates can increase or decrease cap rates even as a property or market stays the same.
For example, let’s return to Property #1 that was available for a price of $1 million at a 6.48% cap rate. Let’s say changes in overall interest rates in the economy push the market cap rate for this property up to 7.5%.
With the same net operating income, the property would now be worth only $864,000 ($64,800 ÷ 7.5%). That’s a $136,000 or 13,6% decline with no changes in the overall fundamentals of the real estate itself!
Now, will that actually happen? Perhaps. But not necessarily.
The relationship between interest rates and cap rates is complex. A change in interest rate does NOT always mean a change in cap rate.
This report from TIAA (Real Estate: The Impact of Rising Interest Rates) showed that interest rates and cap rates do have some correlation (0.7 is the correlation coefficient for statistics nerds who want to know). But it’s not a perfect 1, which means interest rates and cap rates have also moved in different directions in the past.
But the rough relationship between interest rates and cap rates is a good warning. Make sure your property’s location, income, and debt structure are strong enough to withstand future financial shocks.
Conclusion
You’ve now taken a deep dive into cap rates.
In summary, you learned what a cap rate is, how it’s calculated, and what factors affect it. You also learned how to apply it to your personal investment purchases.
I recommend applying what you learn as soon as possible if you want it to stick. Visit a real estate site like zillow.com or loopnet.com to search for a rental property. Then calculate the cap rate and compare it to the numbers in this article.
After calculating the cap rate, ask yourself what you learned about your market and about your personal preferences.
Also keep in mind that cap rates are important, but they’re one of many criteria you should use to evaluate a purchase. You can also read my article How to Run the Numbers – Back of the Envelope Analysis for a more comprehensive look at my approach to property analysis.
I hope you’ll take what you’ve learned and use it with your current or next property analysis. Good luck!
Do you use cap rates in your analysis of investment properties? What are your criteria? What are the cap rates in the local market where you invest? Please let me know your thoughts in the comments below.
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mrprairiefire says
This is so good I can’t stand it. Great summary and thank you for including macro and micro economic factors. So important for buy and hold investors. Great post!!
Chad Carson says
Thank you so much! Anything you’d add from your experience with cap rates or analyzing markets? It’s nice to get different perspectives a well.
mrprairiefire says
I think you covered most of it. As a newbie to real estate investing, using Cap Rate to calculate value for a property can be tricky when dealing with consumer residential property. If your looking to evaluate a duplex or fourplex or a single family home, they are based on comparables instead of how the asset has performed. It’s driven by what the consumer is willing to pay for it.
Comparing commercial multi-units to single family homes/properties with less than 5 units is not exactly comparing apples to apples. At least that’s what I’m finding in Canada.
Chad Carson says
Good point! 1-4 units are sort of a hybrid investment. They do produce income, but their value is not directly related to the income. When I buy them, I use my personal cap rate during analysis. For example, if my goal is a 6% cap rate and the property doesn’t produce that, I’ll pass. Then I also run comps (or have an appraiser or broker do it) to understand if I’m buying below the full value.
David says
Awesome article Chad! Thank you sharing your knowledge with us
Chad Carson says
Thank you David! I appreciate you reading.
Matt says
Chad, excellent article and very well timed! I’m currently looking to purchase a small commercial value add multifamily property and I have a question on value add and therefore increasing NOI when it comes to the CAP. I’ll use your example 2 property above as it illustrates my question perfectly; you’ve purchased it for $850,000 with the initial NOI at $54k of which the Cap is 6.35%. You’ve added value next to increase the NOI to $84k. This next next step is what’s confusing me. You’ve stated the property is now worth $1,000,000 and the Cap has increased to 8.4%, but what comes first in this calculation, the value or the Cap? If the Cap didn’t change your property would actually be worth $1,344,832 ($84,000 ÷ 0.0635).
I’m trying my to understand how both value and Cap are calculated in situations where the NOI is increased.
Thanks!
Chad Carson says
Thanks for reading, Matt! This is a really good question. It points out a distinction I probably didn’t make clear enough in the article. I explained both
1) personal cap rate to use with a purchase AND
2) market cap rate based on the average cap rates for local investors.
In the example, the 8.4% cap rate is the personal cap rate on a $1 million investment. But if the market cap rate is 6.35%, then the full value is indeed $1,344,832. This means the investor has created $344,832 of new equity/wealth by adding value to the property.
I use both types of cap rate. The personal for my own acquisition goals. And the market cap to understand the market value of what I’m buying. Does that make sense?
Matt says
Many thanks for your reply! Yes that makes sense, I guess I’d like to understand how does an investor know which cap rate to use when calculating adding value, specifically with commercial multifamily? As hasn’t the improved NOI increased the market cap or no? Ultimately as a value add investor I’d much rather the market cap rate stay lower so as to increase the value.
Chad Carson says
Matt, if you want to know how much value you’ve created, you always use the market cap. It is what it is. We don’t personally have any say in that. The best sources for those caps are commercial appraisers or brokers, in my experience.
So, if you’re doing a value add deal in order to “flip” it, the market cap is really the primary figure you’ll use.
Matt says
Thank you Chad. I am actually evaluating a deal right now which illustrates my quandary, buyer is asking $1,200,00 with their claimed NOI being $66,224. They are calculating the value based upon a “takeover” cap rate of 5.52%. This is a terrible deal at this price, but rents are below market and there is some value add opportunity. The financial summary is quoting Year 1 cap of 8.15% and a “terminal” cap of 6.5%. In this example this takeover cap rate is driving up the value. In my opinion this is not the market cap rate and therefore I plan to ask my agent to provide a realistic cap rate for this location so I may calculate an accurate property value. Am I on the right path with this thought process?
Rocky says
Thank for the clarity on the subject. I find a lot of people play with the assumptions of vacancy / repairs. I also see to often they don’t evaluate based on some of the other factors you mention. It’s an art to evaluate different cap rates across properties.
Joe says
I have problem with the statement:
“Because a cap rate measures risk, the higher the rate, then the higher the risk.”
I think a cap rate measures Return on Investment (ROI). It does not measure risk.
Just because cap rate and risk go in same direction, it does not mean cap rate is a measure of risk. For example, there are transaction at low cap rate in a high risk market… it called “mistake”
Chad Carson says
Thanks for the comment, Joe.
Perhaps we’re saying the same thing. Because I think cap rates do measure risk when used on the market level because the average cap rates tell you which locations and properties are more risky and less risky (kind of like interest rates in bond markets).
But I also use cap rates as a goal (property’s unleveraged ROI) on individual deals. And I’ve certainly made mistakes, as you say, by buying at too low of a cap rate given that property or markets real risk. I learned the hard way! But even in that case, had I known the real risks up front, I would have required a higher ROI. So, my mistake was a mistake of information.
Joshua D Logan says
Hi Coach! This was a great explanation. I’ve read the comments and still can’t find an answer to an issue I’m having. Why does CapRate examine risk?
Wouldn’t the higher CapRate showcase better profits for the investor? Does this metric only work for commercial of can you use it for residential?
Simple Cleveland Duplex
$1000 in monthly rents for a yr = $12000
$200,000 purchase price.
CapRate = 6
If the rents were higher the CapRate would be higher.
$1200 in rents = $14,400
$200,000 purchase prince
CapRate = 7.2
This higher CapRate would be a better deal. Maybe…. ???
Rocky says
It’s usually the opposite of your scenario for risk.
It illustrates class C properties versus class B properties. The cash flow looks great but the tenants suck and so you end up with more risk and a higher cap rate that never materializes in real life.
Joy says
Curious question..historic bldg in downtown thriving village. Ofc dnstrs and apt upstrs. $2.0 M price. Strong market… touristy. $60000 income, $29000 exp. ….cap rate doesn’t work?
risto says
Thank you, very good and easy to understand article. All the best
RJS says
Thank you!! You explained this better than I could get from Investopedia!! Cap Rates mow make sense to me.??
Dustin says
Thank you for sharing. I look forward to seeing more of your article.
Mark E says
Chad, I’ve tried being a reader, subscriber for a long time but … you seem to be writing to seasoned fellow investors like yourselves and losing almost all newbies like me. Wish you’d work on simplifying and helping others.
Chad Carson says
Thanks for being a reader and subscriber, Mark. And I’m sorry the content thus far hasn’t connected with where you are in the process.
Have you tried my Real Estate Investing 101 article? Or the Real Estate Investing For Beginners – How to Find Your Focus?
Both of those I wrote specifically for brand new investors who are starting from scratch.
Is there anything, in particular, you’re trying to learn or need help with?
Gabriella says
This is excellent!…however my book is asking “goin in average cap rate”…and I dont find any explanation about it anywhere. All I can understand from the solution, that is a higher percentage, but based on what and how to calculate…no words about it.
Any chance can get some help? I would highly appreciate it!
Thanks
Gabriella
Chad Carson says
Hi Gabriella, I believe “going in” cap rate refers to commercial real estate deals where you (1) buy a property (2) develop or remodel it (3) after stabalizing the property, sell it for top dollar. So, the cap rate when you BUY the property in step #1 is your “going in” cap rate. And the cap rate when you SELL the property in step #3 is the exit (or terminal) cap rate. Over a short period of time, the two cap rates may be the same. But cap rates can change, so if cap rates go down over the next couple of years that could give you an extra boost in value above and beyond the improvements you made to the property. The opposite could also happen if cap rates go UP – your value could go down. Hope that helps!
Sudeten says
Coach:
I am trying to wrap my head around this, but frankly it really makes no sense. Here is why:
Take your Property #1 is a 10-unit building available for a price of $1,000,000 as an example:
Here are YOUR numbers:
$9,000 = total monthly rent ($900/unit)
-$3,600 = monthly operating expenses
$5,400 = net operating income per month
$64,800 = net operating income per year (5,400 x 12 months)
6.48% cap rate ($64,800 ÷ $1,000,000)
But let’s say you bought this and were able to do some cost cutting measures and reduced your monthly operating expenses to $2000 per month. That would increase your net operating income per month to $7000 or $84,000 per year. Now your Property #1 has 8.4% cap rate. So, has the risk gone up? I don’t think it has. So, clearly this measurement has some intrinsic problems. Not all properties have the same ratio of operating expense to income. Thus some properties with a lower expense ratio may actually be a better deal.
Here is an example of a 8 unit stable scenario I am aware of for a price of $285,000:
$4,400 = total monthly rent ($550/unit)
– $500 = monthly operating expenses
$3,900 = net operating income per month
$46,800 = net operating income per year ($3,900 x 12 months)
16.42% cap rate ($46,800 / $285,000)
This scenario has been rocking along for about a decade – and rents are about $200 less than they should be given the local market. However, if the new owner keeps the rents the same and spends more on operating expenses (not sure what this would go towards):
$4,400 = total monthly rent ($550/unit)
– $2238 = monthly operating expenses
$2,162 = net operating income per month
$25,944 = net operating income per year ($2,162 x 12 months)
9.10% cap rate ($46,800 / $285,000)
He would succeed in reducing his cap rate from 16% to 9% – does that mean has less risk?
Kevin Hall says
I too was struggling with this. However, I think the answer is it depends on the location and the property in regards to risk. For example, if you can increase your rents or lessen the expenses of a property at a specific value, then your Cap Rate is increased which is good because of an increase NOI.
On the contrary, if a property were to decrease in value because of location, economics, or the age/needed repairs the Cap Rate would also increase but this wouldn’t necessarily be favorable.
I could be wrong, but that is what I’m thinking. My application take away ends up being when I’m analyzing a property I need to determine why a cap rate is high. For example, is the income in the pro-forma skewed favorably for the seller or are the expenses inaccurate. Perhaps its priced low because of the building type, location, or the economics of the area and there are no value add opportunities to change that, but it looks like a higher cap rate.
Hopefully Coach Carson can add some input to correct me if I am wrong and to give us some more clarity on why else a higher cap rate is a riskier investment.
Drew Dodds says
I am still a little confused on the relationship between cap rates and risk and the concept seems to have contradictions to me. So in your second scenario above, you bought a property at a 6.35 cap rate, put some work into it, and now the cap rate is 8.40%. Which make sense b/c the NOI has increased.
But, is it now more risky since higher cap rates mean more risk? Or is it better to look at that now as the new yeild (which you mentioned) and sort of detach it from the cap rate concept altogether? Because you would never sell at that rate b/c in reality the asset is now less risky and therefore demands a higher purchase price??
Further down in the section on future outlook you talk about the dangers of investing in cap rates around 4 to 5% (potentially the same rate as the debt you would need) which makes sense. But isn’t the lower rate less risky and so the asset has a higher price? Or is the concept just that it would be less risky if you used no debt whatsoever? But that seems odd since almost no one would or could use no debt so in reality it is more risky than the cap rate since you have to use debt.
And for syndicators, the goal seems the opposite than what’s intuitive. I would think you buy at a low cap rate and improve it so then it produces more NOI. But it seems that maybe the reality is opposite. Buy at a high cap rate and sell at a low cap rate. It’s just weird to think about that you buy a property that produces more NOI than when you sell it. For buyers on the back end, it just seems like you don’t actually get a good deal because the asset now produces more NOI after the work which is great, but b/c of that, it is more expensive. So to buy it, you would not actually realize that NOI. IDK, just weird to me.
Keith Mayfield says
Thanks so much for this video. It really helps me begin understanding CAP rates
Jeff S. says
Sorry, but not buying this formula as being the #1 basis on deciding to buy a piece. It is just another piece of info’ to HELP you determine if this is a good purchase. IMO, it’s just a marketing tool for real estate brokers/agents to justify higher real estate prices (ie; low cap rate = higher selling price = good for agent). If you buy a rental property with under-market rental rates and/or make improvements to bring up the rental rates, which also should bring up the property’s value, then you can throw the cap rate out the window. Real world: The property (unless bought for cash by someone with deep pockets) will have a debt associated with it and before you buy, you have to make sure “the numbers work”. At the end of the day, no fancy “cap rates” are going to make this a viable long-term investment if the numbers don’t work after improvements and associated overhead are factored in. Just my take from years of the “real world”.