The cap rate is an important indicator used for valuing investment properties. It shows the rate of return an investor receives before debt service and can be calculated by dividing the net operating income of a property by the purchase price. Factors that help establish the cap rate include the property type, location, credit of the tenant, perceived upside in rent, and comparable sales. Different assets have distinct risks associated with them, with multifamily properties generally being viewed as the most stable investment and retail, hotel, and office properties considered to have higher risks.
Property type plays a significant role in determining the cap rate, with investors typically accepting lower returns for multifamily investments due to their stability. Retail, hotel, and office properties are seen as having higher risks, so investors usually demand a higher return and a higher cap rate for these assets. Location also influences the cap rate, with prime locations having more demand and competition, leading to higher prices and lower returns. Secondary and tertiary markets may require higher returns to attract buyers.
The credit of the tenant is another factor that affects the cap rate, with smaller businesses generally requiring a higher return than national credit tenants due to their higher perceived risk. Properties with below market rents may have the potential for higher returns in the future, as investors are often willing to accept lower returns if they believe they can capitalize on increased rent in the near term. Comparable sales are often used to gauge cap rates, with experienced investment sales brokers able to provide insight on how other properties have traded.
It is important to consider all of these factors when evaluating cap rates for investment properties. Investors should also look at other aspects of a property before making an investment decision. By staying informed about the market and using insider knowledge, investors may be able to find deals that offer returns that outperform the market. In the next article, considerations for cap rates in the current market will be discussed in more detail.