Capitalization Rate!

[Ronnye L.]

Just wondering.

Does a hi cap rate mean more cash flow, And a low cap rate means the value of your property is hi? When is to high or to low risky, is it your risk tolerance? I know there are two types of cap rates when a property owner can divide the cap rate with the NOI and that gets the value there property.

[Bill Gulley]

Well, first, understand that my capitalization rate on my investment is totally irrelevant to anyone buying it, it's pure marketing eye wash because your cap rate will never be the same as mine.

There is an inverse relationship to price, a high cap rate used lowers the price, a low cap rate increases price.

This can be looked at on your financial calculator, enter a loan formula, loan amount, period and interest rate, solve for any variable like the payment, now increase the interest rate and solve for the present value or loan amount, you'll see that it is lower, lower the rate and you'll see the loan amount increase. The loan amount represents price or the value of amount bearing interest, the relationship is the same.

While we all talk about a cap rate and cap rates are used in valuations, it's not really a reliable aspect to valuation of small RE projects or investments, in large projects it becomes more valid, in the millions and is why the assessment is adopted in finance.

The difficulty in a cap rate being applicable to small investments is in the development of the cap rate used, it requires the analysis of alternative investments of similar size, risk, marketability and return, that is more difficult to obtain in real estate as all projects are different. Where appraisers adopt a cap rate, they may use other investments, such as a bond or other security.

I have fun playing with the minds of a few appraisers, (take their brain out and toss it around a bit, teasing it and put it back in for a reply, LOL) the issue is that no other investment carries the same risk nor can the risk of ownership of a small RE project  be accurately established, it becomes a matter of assumption and opinion as it can not really be shown. Often, there is no alternative investment that is really similar and cash flow of different amounts presents different opportunities. We accept, generally, 10% as a customary rate to judge an investment, but it is not a rate that is arrived at as it would be in other investments, like securities, where risk is assessed and securities are rated.

So, seeing some property for sale that claims a 14% cap rate, the proper response to the owner or agent would be "how nice for the owner"! That is their rate, their capital cost, their alternative investment alternative, their management and their equity position, yours will not be the same.  

Now, you cap rate or required return may be constantly applied to other properties, your alternatives can be assessed, but your risks assumed will not really be the same, but such differences can be ignored in your assessment. :)