CAP rates like I’m five

[Nick Mauldin]

So as I understand, a CAP rate is based on NOI. However, I’ve also been told that CAP rates have to do with risk. Question, why would I want a higher CAP rate if it brings increased risk. For example taking a 6 CAP to a 9 CAP. Thanks for the help!!!!

[Justin Brown]

Hey @Nick Mauldin! CAP rate is a bench mark for judging dissimilar properties, and for telling you how well its performing based on the cost of the property. The higher rate doesn't relate to risk necessarily but can help get you in the ball park on if you want to analyse a property further. CAP rate is short for capitalization rate, meaning how long till you pay off the asset cost with the net income. So lets say for easy numbers...I have a two unit property that would cost me 100K that is making me a net income of 10K a year and a 3 unit that was 200K and was making me 16K a year.

1.) 10,000/100,000 -> .10 -> 10% cap rate, or ten years to capitalize on my investment. 

2.) 16,000/200,000 -> .08 -> 8% cap rate, 12.5 years to capitalize on my investment. 

So though the two options are a lot different I can quickly see that the first option is a better cap rate even though its less cash flow. At this point it really depends on what your investment strategy is. Some people don't care about cap rate and want to look at the cash flow per door, or cash on cash return. But its still a good tool for at least giving you a 30,000 view to get you in the ball park on if this is something you want to look at. You can also use this to see what is normal for your area on what is a good deal or not. I know in some places they wont touch something unless its a 10% cap rate, in other areas they would jump at 6%. Any folks want to jump in on that part of the discussion? 

Good luck Nick! 

JB.