should one look for a high or low cap rate?

Even though I read the definition of cap rate, I still can't tell if it is more desirable for the cap rate to be low or high.
In Buying Property - Asked by Erma S. - Aug 30, 2011
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Answer(s)

Alan E.
Broker/Agent
Saint Petersburg, FL

I would also add... the cap rate is only as good as the underwriting that got you there, meaning, a cap rate is arrived at by using a financial formula, and if the numbers within the formula are in error/misstated, the cap rate will be too.

Aug 30, 2011
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Timothy H.
Broker/Agent
Monarch Beach, CA

The desire is down to the amount of risk you are willing to take. The higher the risk to you the more reward you are going to want. For Example US bonds, very low risk so little reward. The market has already set the levels of return for you as previously explained. Those levels are determined by product type, location and Credit of the tenant. There is no clear answer to your question, of course it is desirable to have a higher cap rate and receive more income but then everyone wants that , which in turn drives the price up and you guessed it down goes the rate.

Aug 30, 2011
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Lee S.
Researcher
Scottsdale, AZ

Cap rate is your rate of return on your investment. You want 10% return? That's a 10 cap. Why not always look for 10+ cap rates?
A low cap rate is for properties that have guaranteed funding (corporately guaranteed leases, etc). You don't make much but the money is as good as in the bank.
A high cap is usually found in more risky investments (vacant building/shopping centers) where you'll have to find a tenant or have to do some renovations.

Aug 31, 2011
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Rick L.
Appraiser
Cleveland, OH

High going in low coming out.

Sep 8, 2011
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Virginia "Ginny" S.
Broker/Agent
Rochester, NY

It really depends upon a couple of factors.
1. Your risk tolerance
2. Your dominant financial driver and purpose for the property
3. What the going rates are in your market
I tell my students to first determine what they want from their property
1. Cash flow
2. Long term appreciation
3. Tax advantages
While all can be achieved simultaneously chose one path that drives your perameters for making an offer.
Feel free to contact me directly for more a more detailed conversation.

Sep 15, 2011
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Jason M.
Owner/Investor
Ocean City, NJ

There are really two types of Cap rate. There is the Market Cap Rate and the Desired Cap Rate and in General the Cap Rate or Capitalization Rate is a quick way to determine a Basic Return on an investment before Taxes and Depreciation. If you think of Cap Rate in the most basic of ways, $100000.00 deposited(invested) into a bank account paying 2% interest will return $2000.00 at the end of 12 months +/- (due to compounding) while $100000 invested into a $100,000 Property that has an $8000 Net Income after all expenses and before Taxes and Depreciation will have an 8% return. Therefor one could say that the Cap Rate at the Bank was 2% and the Cap Rate in the Property was 8%.
The Market Cap Rate is often used by Commercial Lenders and Appraisers to determine the Value of a Property being considered for a New Loan. By knowing the NOI and the Sales Price of several properties in that specific Market, a Market Cap Rate can be determined. Then by dividing the NOI of the Property being appraised by the Market Cap Rate a Value can be determined. (This appraisal method is called the Income Approach to Value) and is one of 3 ways used to determine Value.
In a similar respect, an Investor can determine what price to offer on an investment property based on either the Market Cap Rate or on their Individual Desired Cap Rate. In general, a Class A Property in a Class A area will have a lower cap rate than a Class C property in a Class C area, mainly because the Class A Property will have less risk due to higher desirability. However, a motivated seller of a Class A property who has been unable to sell the property because the Market is soft, may be able to increase chances of a sale by increasing the Cap Rate at which they are offering the property.
The higher the Cap, the Lower the Price and therefor the better the Return on investment. to the buyer all other criteria being excluded from the decision. In general, in an up market, owners can demand lower cap rates and therefor higher prices on their property regardless of Class and Location and in a down market, Buyers can demand Higher Cap rates and therefor lower prices on their offers.
So, your decision as to which to look for should actually be based on multiple criteria, one part of which will be the cap rate. If you find a great property say a Class B property in a Class A area, with a highly motivated seller, who is offering the property at a 7 Cap (the market cap rate), there is no reason not to at least attempt to purchase it at a 10 cap or better Cap (the desired Cap rate.

Sep 15, 2011
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Brad J.
Broker/Agent
Tyrone, GA

CAP rates are a snap shot that allow investors to quickly compare multiple properties. The capitalization of the purchase price based on the NOI offers little insight into the actual return on investment that could be earned over the expected hold period. CAP rates can either attract or discourage investors inappropriately. Since NOI does not include financing or long term capital expenditures (not to mention leasing costs) there could be little correlation between and “attractive” CAP rate and a well performing investment.
CAP rates are useful when properly calculated and understood as stated above. The location and condition of an asset are always important; however, cash flow is the most important element. Therefore, the credit worthiness and term of the tenants are paramount when calculating a CAP rate. Savvy investors should assign a CAP rate to each tenant based on their long term ability to pay rent and occupy the space. A weighted average, or blended, CAP rate can then be established.
I always prefer to prepare a pro forma based on the investments goals of my client and factor in realistic market and capital expense assumptions. We can then understand the long term annualized return, or IRR, as well as apply a reasonable discount rate to determine our purchase price range. Only a well-researched and thorough pro forma can address the many long term risks of ownership and factor that back into a purchase price. After all…God is in the details.

Sep 15, 2011
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Dawn P.
Broker/Agent
Fort Worth, TX

Thru eyes of an investor, buying at a high cap rate is best for a 'better deal' for a buyer, selling at a low cap rate is a better deal for the seller because the building's value is greater selling with a low cap rate. Hope this helps....

Sep 15, 2011
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Ann Marie m.
Appraiser
Pompano Beach, FL

Ideally you buy at a high cap rate (more income for each dollar invested) and sell at a low cap rate (more dollars per dollar of NOI).

Sep 15, 2011
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W.C. W.
Owner/Investor
Quakertown, PA

Erma,
The rule of thumb would be that the higher the cap rate or return on investment the lower the cost of the asset you are purchasing. The lower the cap rate or return, the higher the cost of the asset.
Many things determine cap rates including cost of funds. The most determining factor is what an investor wants as a return on their investment. Another rule of thumb is higher the risk, higher the return, lower the risk lower the return. I hope this gives you better insight to the cap rate formula.

Sep 15, 2011
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Robin C.
Appraiser
Bartow, FL

For beginners, the nuance can be counter-intuitive. To say "I want a big return on my cash." is not the same as "I want an investment with a high cap rate." The rate is an annual return of the total sale price, not just the down payment.
A more down to earth analysis of a cap rate might be the number of months or years it takes to recover the initial investment. If a property sells for $100,000 and it has a 10% capitalization rate, it will take 10 years to recover the $100,000 if the rental income never increases in that 10 years (and temporarily ignoring the falling value of your currency) because the cap rate is based only on net income before debt service. All of the operating expenses are deducted from the income to develop the rate. So we can see that a 12% cap rate equates to 8.3 year period to recover the investment (loan amount plus down payment), a 8 year cap rate equates to 12.5 years.
Suppose a 10 cap (10 year payback) is average in that market for that property type, and the candidate property is showing an 8 cap (12.5 year payback). I can quickly see that either
1. the income is below average for the market ($8,000 NET income divided by $100,000 price)
OR
2. that the asset is priced at a premium. ($12,000 NET income divided by $150,000)
If the income is below average for the market then there's a lower risk of the tenant(s) leaving because competing properties' rents will be lower.
If the tenant is a national retailer or a public agency and there's a long term lease whereby the tenant pays any and all operating expenses, then that asset would be priced at a premium because, as others have said, it's like money in the bank and risk is lower.
What's really more interesting to investors is the Cash on Cash Rate, which is the Capitalization Rate of the Equity.
Suppose the $100,000 property with $8,000 NET income, with a 25% down payment and a loan with 20-year amortization at 6% for the other $75,000. The investor brings $25,000 cash and receives $8,000 annually: the equity cap rate might appear to be a staggering 32% but we must deduct annual debt service. Annual payments are about $6,500 leaving $1,500 "Pre Tax Cash Flow". $1,500 divided by $25,000 is 18.75% which is 5.3 year payback (1 divided by 18.75) of the Down Payment.
It depends on your appetite and tolerance for risk, short term and long term strategies, and forward looking opinions, and location.

Sep 15, 2011
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Joe D.
Broker/Agent
Crown Point, IN

I think your tenant is the most important. Find out about the business and the lease. I would really question the sale of a building by it's main tenant, or at least don't expect them to stick around long. You can have a stellar cap rate today with the tenant moving out tomorrow and you being stuck holding the bag on the property with a cap rate of zero for the next few years. This is not hearsay, this is hands-on-seen-it-happen truth. Then again it might be just a desperate seller. Same thing can happen with low cap rates as well. Know your tenants and building. Ask yourself "if everyone moved out, would I have a good building to move people into?"

Sep 15, 2011
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Bill L.
Developer
Mason Neck, VA

When it comes to Cap Rates, you want to buy high and sell low.

Sep 15, 2011
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Curt G.
Broker/Agent
Texarkana, TX

For sellers low cap rates are best because they mean more money in the sellers pocket. For buyers the CAP rate you are looking for depends upon your goals. Are you looking for monthly income with little landlord responsibility? Then a mid cap range could be good for you, say an 8 % Cap, this would mean the tenant was relatively substantial with good credit rating and minimal Landlord responsibilities. Say a Family Dollar, Dollar General or Advance Auto. If you want more risk and more monthly income you could go into a multi tenant strip center at say 11 or 12% CAP rate, this would take more work on management but more return on money. If you do not need monthly cashflow and are looking for a long term investment then buying at a lower cap rate of say 6% a home depot or some big box with a superb credit rating and a very long lease, this would be the way for you to go.

Sep 15, 2011
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Gerald T.
Broker/Agent
Edmonton, AB

Everyone has answered this so well, there isn't much to add, except that watch out when you find a building with a seemingly better than expected cap rate. It is not unusual for some sellers to "massage" their income statements to provide a seemingly better cap rate. A knowledgeable agent will help you to detect inaccurate cap rates.

Sep 15, 2011
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Joel O.
Broker/Agent
Canton, GA

This all depends on YOU.
What age are you in the buying cycle?
Meaning are you in wealth creation mode or wealth preservation mode?
Just starting out many will pursue value add deals with stronger returns going in and more risk to generate wealth. Later on after years of high returns and moderate to high risk the buyer tends to change.
The buyer gravitates toward preservation mode and keeping the wealth.Instead of a headache they are looking for a cash flow stream that is safe and keeps above the pace of inflation with moderate returns.
Wealth accumulation as an example would be an apartment building with bad management and deferred maintenance and vacancy issues.
Wealth preservation would be a triple net lease signed by a credit tenant where you get mailbox money every month.

Sep 15, 2011
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Jo B.
Owner/Investor
Denver, CO

Erma, do you want to make money from day one? Yes, look for a high cap rate, but it has to represent the actual numbers of the property. Income minus expenses, go one step further and include debt service as well, if your cap rate is at 9 or 10 % the deal is a sure thing. If the answer is NO and you are looking for appreciation only then it does not matter, because you will trade location versas income. Class A and B properties generally have low cap rates and provide little (if any) monthly cash flow. Depends on your strategy. Hope this helps.

Sep 15, 2011
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Martin Z.
Chattanooga, TN

The only thing I would add is if the leases are new and the cap rate is high, watch out. This could mean that the seller gave out tons of incentives to the tenants in order to have the higher cap rate. There is a good chance the tenants will move out or demand lower rent when the leases are up for renew.
Check out the lease rate for the areas around, if the lease rate is too high, there is a big risk that you will have to lower the rent in the future in order to keep the current tenants. This will lower your cap rate.
The other thing you will have to watch out is the operation cost. Sometimes there are hidden cost to the owner even with NNN leases. This will lower your net return. You will have to read the leases to find them out.

Sep 15, 2011
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jim w.
Developer
Phoenix, AZ

Alan E. says it best. The cap rate is only as good as the pencil that pushes it. Instead of looking at cap rates you need to learn how to formulate one for your portfolio. Cap rates at best are simply a rule of thumb for the novice investor. Create your own formula for cap rate structure and keep your pencil sharp at all times!

Sep 15, 2011
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Geoff M.
Lender/Mortgage Broker
Auburn, CA

High if you're buying, low if you're selling.

Sep 15, 2011
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Tony M. G.
Broker/Agent
Ontario, CA

If you are the buyer you want a higher cap rate. If you are the seller you want a lower cap rate.

Sep 15, 2011
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Maria Ilsun C.
Broker/Agent
Orinda, CA

Ha ha : ) I was about to answer thinking you didn't get any responses - but I see you have a lot of courteous gentlement at your rescue! In short, high cap rates mean more income - low cap rates mean low income. If the property is valued correctly, higher cap rates also mean there are issues or higher risks - or in a soft market, lower demand.
An example would be a post office with a new, long term lease with the federal government. A very low cap rate would be expected.

Sep 15, 2011
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Ninous A.
Broker/Agent
San Francisco, CA

While cap rate is a good indication of value, one should look beyond the offered cap rate on a property. Real estate investment differs from stocks or bonds. Most people buy real estate for a long term hold and future increase in value. A prudent investor should look beyond the simple cap rate. As an example, if a property is offered at say 6.0% cap rate and is encumbered with a straight leases say for 20 years and absent of annual increases, there will not be an increase in the value of the property anytime in the near future. However, if a property is listed at say 4% cap rate and is leased for way below the market rents and there is a year or two left on the lease, the value should be adjusted based on the future income steam and it may prove to be a better investment in the long run. So Cap rate alone should not be the only factor for a prudent buyer to consider when acquiring real estate. Other factors to be considered are based on its zoning and future development potential should also be considered.

Sep 15, 2011
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Dennis D.
Lender/Mortgage Broker
Tarzana, CA

A cap rate is a moment in time. It is a short term indicator of value. An internal rate of return gives a long term value. In general you will see lower cap rates in desireable area with buildings in good condition. The higher cap rate is there for a reason. Ask yourself if you can fix the reason and if you can; you will obtain a good return on your money
Dennis Dishaw
President, ACI Capital

Sep 15, 2011
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Matthew O.
Broker/Agent
Solvang, CA

If you're buying real estate, you're going to want a higher cap rate = higher rate of return. Ie. 6 CAP = 6% net rate of return and so on.

Sep 15, 2011
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Billy B.
Broker/Agent
San Antonio, TX

high

Sep 15, 2011
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Marty H.
Broker/Agent
Lenexa, KS

If you are buying you want a high cap rate as that means you are generating more income from your investment. When you sell you shoot for a low cap rate as that means you are getting the buyer to pay more for the income stream being sold. With that said, you have to be sure the numbers used to arrive at the cap rate are factual and that they aren't subject to suddenly change after the transaction closes.....for example: the failure of a tenant, a struggling economy resulting in your tenants demanding rent reductions, etc.
Additionally, Cap Rates are best relied on by all cash investores. Once financing comes into play there are a lot more variables to consider and it becomes more complex to actually determine the investor's return on investment. Whole books have been written about this subject and large investments may require a sophisticated analysis.

Sep 15, 2011
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Rosemary L.
Broker/Agent
Sparks, NV

Cap rates have an inverse relationship with the price. High cap rates are great for the Buyer. Low cap rates are great for the Seller. Usually high cap rates indicate higher risk, and low cap rates indicate lower risk, so it depends on the investor's investment objectives.

Sep 15, 2011
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Bruce K.
Broker/Agent
Hermosa Beach, CA

It is not by itself a meaningful measurement as it measures the return on investment based on a single moment in time. Furthermore, it assumes all cash. Factors such as type of lease, exposure to increases in operating expense in not some variant of a triple net lease, rent escalations, remaining lease term, current lease rate versus current market rates, type and age of the property and its ability to attract tenants should it become vacant, is the property a "value-added" property and many other factors. Perhaps that is why time based tools like IRR or FMRR are better suited. Of course IRR has assumptions that make the return only good for comparision as the periodic cash flows are assumed to be reinvested at the IRR rate, so FMRR is a more accurate measurement of return. However, your underwriting skills greatly impact the FRMM return as to what is a realistic NOI or distributeable cash flow.

Sep 15, 2011
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Joe A.
Broker/Agent
Albuquerque, NM

Hi Erma - a capitalization rate is a measurement of the return on a real estate investment; So buyers would like higher cap rates and sellers want lower cap rates. The market dictates cap rates and so they vary based on the quality of the property, location and income stream. Generally, if you want a high cap rate you might have to buy something of lower quality, in a poor location or more maybe vacant (more risk). The lower cap rate will equate to a higher quality property in a better location with less risk.

Sep 15, 2011
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Bobby L.
Broker/Agent
El Dorado Hills, CA

A cap rate essentially is an expression of an expected cash return year one before debt service or taxes. Operating expenses (excluding capital improvements) are deducted from gross collections. The result is then divided by purchase price and is expressed as a percentage.
As a broker, all too often I see prospective purchasers trying to chase down the deal with the highest cap rate. High cap rates are typically indicative o higher risk. Frequently, the properties with the highest caps are on properties which are located in inferior areas or they may be under occupied with no real prospect of adding tenants anytime soon. I read an article the other day that postured that those properties which are 15-20% vacant will remain at flat rental rates for the next 10 years.
If you can find a decent, market-rate cap on a property with solid real estate fundamentals (infill location, newer construction, near full occupancy) I would recommend that you pursue these properties as they are, given the current economy, resession resistant and these properties will be most likely to increase rents as we exit this downward trend.

Sep 15, 2011
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Todd R.
Broker/Agent
Encino, CA

Got in late. Looks like a lull of answers from Aug 30 to Sept 8. Cap rates (CRs) all about the risk/reward ratio. Plus, they don't always determine the actual rate of return on investment if leverage is used. So, sometimes a "cash on cash" return will be higher or lower depending on other factors in relation to CRs.
But, CR is a great place to start when you have good net operating income (NOI) numbers. Botton line is that the CR is one of a few tools in the financial analysis tool kit that should be employed when determining suitability in the acquisition of an investment income asset.

Sep 15, 2011
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Paul S.
Appraiser
Saint Simons Island, GA

Appraisers in the city develope cap rates by dividing comp sales prices into the NOI and appraisers in smaller populations develope a cap rate from financial institutions by using several methods with the most accurate being Elwood J Factor which has seven variables to enter. Either method results in approximately the same cap rate.

Sep 16, 2011
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ALAN S.
Owner/Investor
Manhattan, NY

My stratergy is a combination of both. A large percentage of my investments is in lower cap type properties. The balance of my investments are spread out over a multiple of higher cap properties. However, the amount invested in each is much lower, thereby spreading, and lowering the risk, while creating a larger return on investment.

Sep 17, 2011
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ALAN S.
Owner/Investor
Manhattan, NY

My stratergy is a combination of both. A large percentage of my investments is in lower cap type properties. The balance of my investments are spread out over a multiple of higher cap properties. However, the amount invested in each is much lower, thereby spreading, and lowering the risk, while creating a larger return on investment.

Sep 17, 2011
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Catherine S.
Broker/Agent
Melbourne, FL

There is a common misconception when using the terms CAP RATE (Capitalization Rate) and the acronym IRR (Internal Rate of Return.) The two calculations are completely different but often tossed around in property conversations like they are the same. THESE CONCEPTS ARE DIFFERENT. The capitalization rate, or discount rate, calculation only uses the net operating income (year one) and value. IRR takes the entire investment's value, net operating income AND the sale proceeds (ie...the whole package.) So back to your question- high or low cap rate? That question should go back to the investor. And just a re-cap (no pun intended) cap rates are not the same as IRR's.

Aug 15, 2015
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