How does the Cap Rate Work

[Daniel P Willis]

So I have a single family home and a trailer that I rent out and my wife and I are looking at purchasing a triplex or quad. How does the Cap Rate work and at what time does that become relevant? I always try to learn as much as I can before making an investment and most of the forms that i've seen just say that cap Rate isn't something you have to worry about until its a commercial property. Why is this, why doesn't it matter and how does it work? 

     Any help is much appreciated, I would also like to know your experience with using Cap Rate and how it helped you in your investment, if its not to much trouble. 

   Thank you. 

[Ned Carey]

@Daniel P Willis if you are using financing then you take the NOI and subtract the principal and interest. The amount you come up with is your net positive cash flow. Take that number and Divide it by the amount of cash you put in. This gives you the cash on cash return.

The reason you do not take the financing into account in calculating cap rate is that cap rate is a measure of the buildings financial performance. Imagine you are buying a business. You want to figure out how much that business is worth. Is the business worth more or less because you finance it? The business is worth what the business is worth. How you pay for it and your ultimate return is a different issue. The same is true with a building.

I don't use the BP calculator so I can't really comment on that.

@Rosston Smith made a comment the deserves to be expanded on. Higher cap rate is NOT necessarily better. 

For a given building, the amount of cash flow is a given (you might argue over how much exactly that cash flow is, but it is what it is.) So if you pay a lower price and therefore get a higher cap rate that is always good. Paying more for the same building means a lower cap rate and is always bad. 

However there is the market view of cap rate. If a building is selling for a high cap rate, it is because the market perceives it as a higher risk. People want low risk so they pay more for properties they perceive as low risk. This drives the prices up on those buildings and therefore the cap rate down.

In general low cap rate low risk. High cap rate means high risk. 

Another factor is that cap rate is a measure at a given point in time. It does not figure in the appreciation of a building which could be the most significant profit potential of a property.