Why are cap rates important in commercial real estate

[William Costello]

The result of the cap rate calculation is important because it provides investors with a lot of information about the value of the property, the risk in acquiring it, and its potential return. For example, a higher cap rate indicates a higher potential return, but it also indicates higher levels of risk, which means that the price an investor may be willing to pay is lower.

For example: An investor was considering purchasing one of the two properties.

Property 1: $100,000 NOI / $1,000,000 Purchase Price = 10% Cap Rate.

Property 2: $500,000 NOI / $6,250,000 Purchase Price = 8% Cap Rate

When comparing these two potential purchases, it is safe to assume that Property 1 carries more risk because it has a higher cap rate. Conversely, this means that Property 2 has less risk, which makes it more expensive per dollar of NOI produced. In other words, the relative safety means that an investor must pay more for a lower return.