Simply put. If an investment throws off an income of $10, and my desire return is 10%, how much am I willing to pay for that investment. The answer is $100. That is a CAP rate of 10. So if you have a building that throws off $100,000 of NOI (revenue minus operating expenses, but not debt service) and you want no less than a 10% return, you pay no more than $1 million for it. Therefore, the CAP rate has an inverse relationship with the purchase price. The higher the CAP rate, the lower the price. The opposite is true.
The CAP rate should be a personal thing. You look at your alternative investment opportunities at a particuler time. If the banks are offering 1% return on your deposits and you can get a 6% return (6 CAP), that may be a decent investment. But you must assess the risk of investing in real estate instead of an FDIC insured deposit. On the other hand, if a AAA corporate bond is returning 6%, then a riskier RE investment may require a higher return say may be 10 CAP (10%) or higher ?
So CAP rate should be a very personal investment tool because everyone has a different investment strategy. Unfortunately, most people have no clue what it means, including most of the brokers and bankers. As a result, everyone is walking around quoting CAP rate, CAP rate thill their face sturn blue. What people are doing is quoting CAP rates as a comparable...an indication of what the going rate is among commercial estate buyers and sellers.
Somebody said earlier that CAP rates only tell part of the story because it does not address debt service and he is absolutely right. To make things worse, in the last few uears, people, especially the borkers, have been using CAP rate as a comparable sales tool, giving no consideration to cash flow and IRR. As a result, CAP rates has been driven lower and lower to 3 and 4 CAP, meaning prices have gone higher and higher with no regard to profitability. The most frequent comment I heard was,"well that is the going CAP rate". Thus the commercial real estate market went the way of the residential real estate market which uses comparable sales approach only...and we know what happened there.
So ask yourself a question, as an investor, are you willing to march up the hill with everyone else and line up at the cliff to take a giant leap of faith just because someone else wants to commit suicide? or are you going to look at your personal investment strategy, given all the investment options , and assess the risk you can afford to take?
Having said that, do look at CAP rates when you sell because you want to know what people are paying but never use CAP rate as a benchmark to buy. Do use IRR or a simple % of cash on cash return but pay attention to you debt service coverage ratio (NOI divided by debt service). You want a healthy DSC of at least 1.3 because it tells you whether you can pay your mortgage or not.
Feb 3, 2011