Simply put, a Capitalization rate (cap rate), is a rate of return you can expect to receive from a property, assuming you have no debt or mortgage on the property.
An example is as follows:
If you buy a property for $1,000,000 all-cash, and the property has an NOI of $70,000, your cap rate would be 7%.
(NOI Purchase = Cap Rate)
What happens if you paid $1,150,000 for the same property that gave you the exact $70,000 NOI (remember, you are assuming all-cash purchase)
$70,000 $1,150,000 = .06 (6%)
The higher the cap rate, the higher the anticipated returns. If you pay more for a property, then the cap rate will decrease, meaning a lesser return. This makes sense because your cost basis (the price it cost you to purchase the asset) has increased.
Play around with the equation above and you’ll see what I mean.
SHOULD I BASE MY INVESTMENT DECISION OFF OF THE CAP RATE?
NO, NO and NO! If a deal is being advertised with a higher cap rate, it does NOT mean it is a better deal.
If you look at a rough part of town, you may notice that the cap rates increase. There’s a good reason for this. Generally, the properties with more risk have higher cap rates because in order to attract investors, they need to be priced reasonably. If it requires more work, the investor will want to receive greater returns.
Think of it like this: if you can buy a Class-A, gorgeous asset in the best part of town at a 5% cap rate or a run-down property in a bad part of town at a 6% cap, is it worth the 1% return to entice you to take on the headache? Probably not.
So, if you see a deal being advertised for a 10+ cap, depending on the location and asset class, always go in skeptical. You’ve either run into a money-pit or a gold mine.
WHY DOES A CAP RATE MATTER?
Although a cap rate does not tell you the entire story of a property, it allows you, as a potential buyer, to quickly vet deals from a high level. IT will not tell you the nitty-gritty of the day to day operations related to that asset, but it’ll show you what you can expect.
For purposes of this blog post, i won’t get into more detail, but if you have any more questions ,please feel free to email me at Jason@3pillarsrei.com