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)
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