Clarification on Cap Rates

[Scott Prock]

Greetings!

I just read an article by Forbes where the author - Brad Thomas - mentioned something regarding cap rates that has me confused.

Quote - 
"As a REIT analyst, I use cap rates on a daily basis for comparing the values of various buildings that are bought and sold. In general, a lower cap rate indicates there is less risk associated with the investment (due to increased demand) and a higher cap rates can be associated with higher risk alternatives."

I'm not familiar with what an REIT analyst is, but I thought the higher the cap rate the better?!? I mean using the example in the article of a property value of $1,000,000 and a NOI of $100,000 would be 10% I would think if the property's NOI was $200,000 that would be more desirable. Unless my understanding of NOI is incorrect.

Isn't the Net Operating Income the income generated after expenses are deducted, meaning the cash the owner gets after paying the operating costs. (not including the mortgage payment)

Am I misunderstanding something?

... Scott

[Ned Carey]

@Scott Prock A REIT is a real Estate Investment Trust. So an analyst for one, would be doing very sophisticates analysis of larger commercial properties.

Remember the general rule. "Low risk low reward, higher reward means higher risk."  One of the sharpest members here @Jon Holdman put it better, "higher reward means higher potential reward."  But there is risk you may not get the reward that is expected.

So if a property sells for a high cap rate (lower price higher NOI ) it is because the market believes it is a riskier property and will only pay a lower price. If a property is perceived as lower risk, the market will pay a higher price. As your quote above says, because there is more demand for that "Safer property" it gets bid up to a higher price = lower cap rate.

Here is where many that formally trained in real estate but are not as familiar with creative deal making miss an important point. Not all properties get the same market exposure and not all properties sell at "Market Price."  The explanation above is how the market as a whole reacts to perceived risk.

However for a Specific building, paying a lower price means higher returns and lower risk. Lets use your example above, the property has $100K NOI. If you pay more for that property does that make it a better property? No the property's location, quality, current tenants, expenses do not change just because you pay more. The same is true if you pay less. The quality of the property is the same.

So if you pay $800K for that building you have less risk and better returns than if you pay $1.2 million for the same building.

Now many will say if you offer $800K and the  market believes it is worth $1 million then someone will outbid you. However that is not necessarily true. It tends to be more true the larger the property,  and the more sophisticated a seller is. However properties are bought at bargain prices every day by people who are sharp negotiators or who simply are able to see value where others do not.