However, what does it mean by Cap Rate. Mathematically, Cap rate is Net Operating Income divided by total current market value of the property. This means that when Net Operating income Rises, Cap Rates will rise. However, if current market value increases, Cap rate will compress.
Back to the real world
Armed with the definition for cap rate, now we will know what the real estate companies are talking about. If they bought a piece of property with an annual Net Operating Income of 1 Million and the Current Market Rate for such a Property is 10 million, then the cap rate will be 10%.
Is it better to have a lower or higher cap rate
It doesn’t really matter if the Cap Rate is up or down. What really matters is what is causing the Cap Rate to move the way it does. To give an example. You will like the asset value of your property to increase. So if market value is the factor that is increasing, you will be glad that the cap rate has gone down. However, if the cap rate has decreased because your Net Operating Income has decreased, it will be a bigger cause of worry for you.
Cap Rate and Yield are the same, yet they point in different direction
Mathematically, Cap Rate and Yield are the same. However, they are not the same in the way investors use the two terms. When investors talk about yield, they are often the buyers seeking a high and sustainable yield. However, when Cap rate is used, it is either the seller or the existing owners of the property who central to the transaction.
Cap Rate is not the same as ROI
While cap rate is also the yield you get out of the asset, it is not the same as return on investment. Remember our initial assumption that the asset is bought with 100% cash. This means that the ROI can be tweaked through a good mixture of debt and equity, the cap rate cannot.
We hope from what we have explained thus far, you have a greater appreciation of what cap rate is and why it matters.