Newbie Question - Cap Rate

[Nicholas U.]

Hello all!  Newbie investor here and I was hoping for some clarification on Cap Rates.  Currently I own 1 rental and looking to buy my first multifamily investment property, but I am cautious and want to make sure I fully understand what I am getting into.

So reading about Cap Rate it seems pretty easy to understand... CAP = NOI/Purchasing Price.

Now this is where I feel like I am losing it... Cap Rate measures risk and rate of return; however, what I read is generally that the lower the Cap Rate the better. But that means the lower the NOI the lower the risk.

Example: One of the properties I am looking at I believe is valued around $190,000.00. It is a 3 unit multifamily that could get on average about $800.00 per unit. I calculated NOI on the property believing that after expenses (not including mortgage) I would be making around $19,000.00/year as a conservative estimate. So this would = 10% cap.

But if we just dropped the NOI down to $10,000/year then this would be a 5% Cap. What am I missing? Wouldn't the higher the NOI reduce the overall risk?

I feel like I am missing something blatantly obvious. 

Thanks!

[Manny Cirino]

Originally posted by @Nicholas U.:

Hello all!  Newbie investor here and I was hoping for some clarification on Cap Rates.  Currently I own 1 rental and looking to buy my first multifamily investment property, but I am cautious and want to make sure I fully understand what I am getting into.

So reading about Cap Rate it seems pretty easy to understand... CAP = NOI/Purchasing Price.

Now this is where I feel like I am losing it... Cap Rate measures risk and rate of return; however, what I read is generally that the lower the Cap Rate the better. But that means the lower the NOI the lower the risk.

Example: One of the properties I am looking at I believe is valued around $190,000.00. It is a 3 unit multifamily that could get on average about $800.00 per unit. I calculated NOI on the property believing that after expenses (not including mortgage) I would be making around $19,000.00/year as a conservative estimate. So this would = 10% cap.

But if we just dropped the NOI down to $10,000/year then this would be a 5% Cap. What am I missing? Wouldn't the higher the NOI reduce the overall risk?

I feel like I am missing something blatantly obvious. 

Thanks!

 I understand what is tripping you up let me explain what I learned over time.

higher cap rate are usually in worse neighborhoods which means the tenant pool is high risk. Higher cap rates could also mean the the property is vacant or needs extensive renovation.

lower cap rates are usually b and a class properties in nicer areas or bigger markets. This makes them sturdy investments because the resale value most if these property's sit in a prime location. 

Now a high cap rate could just be someone trying to exit and investment and the seller is delusional and greedy. And the low cap rate is just not a deal at all. And a high cap rate could be a home run if you are buying it off market which is the ideal scenario you want to buy in.

There is no right or wrong answer. You have to determine your investment style and risk tolerance. Maybe you like safer places to put your money or maybe you like to ad value and aren't afraid to invest in ghettos.

The best way to make sense of the deal sometimes is to evaluate the cash on cash return. For example

if you buy a 190,000 property with 20%(38,000) down and your noi is 19,000 then your cash on cash return 50% of coarse I am not including debt service in the calculation to keep it simple. But just want you to see a different t angle. If you make 50% return on investment and you make your initial investment back in 2 years is it good to you?