Understanding Cap rate

[Suhaib Rehman]

Fellows, 

I am finding the cap rate difficult to grasp especially how it is used in the deals. What I am  not clear about it whether cap rate determines the property value of property value determines the cap rate

Cap rate = NOI/Price

Price and cap rate are inversely proportional to each other.

Let's say you are looking for a deal, the purchase price is 1Mil, with NOI is 50k. Going in Cap rate = (NOI/Price ) in percentage

Now, the going-in cap rate is 5%. Let's assume that this is for a class B property in Nashville TN. For going in rate, as a buyer we can negotiate the price down, which will increase the cap rate. What makes a good cap rate for this property class in that market, so we know what to offer for that property( consider that the rest of financial CoC, IRR are up to the mark)? As a buyer is our intend is to bring the going in cap rate to market rate, or higher than marker rate, for class B property in that market so that our offer become attractive to investors?

Now consider the exit/terminal cap rate, exit after 5 years,. which we want to calculate during our underwriting process and also include in the PPM.  I noticed that various underwriter use a exit cap rate to value the property in future. Which is opposite to what we did during purchase where we use the proposed purchase price to calculate the cap rate. What is the intend of exit cap rate here, and how is it related to goin in cap rate? 

Thanks 

[Russell Brazil]

There is no good or bad cap rates. 

The cap rate is a reflection of the risk in the asset and/or the market.  Higher class properties will have lower cap rates than a lower class property in the same market. That is reflective of the lower class property being higher risk, and therefore it will have a higher cap rate.

Cap rates within a market are amazingly consistent. Most of the Class C properties will have similar cpa rates, the Class Bs will all be similar and have a lower cap rate than the C, and the Class A will have the lowest cap rate.