As can be seen, there are many factors that could impact the cap-rate for a particular asset at any moment. The best way to decide if a cap rate is good is to review the asset against other comparable assets, compare it with sales at the time of purchase, review the cost of capital, and assess the risk tolerance and risk profile of the investor. There are lots of publicly available data to determine whether a cap rate on a particular asset matches the risk/return of similar assets. After performing proper diligence and accounting the variations in the comp set for potential risks, an individual can determine exactly what a "good” cap rate is.
Lease Strength. A lease's strength can be determined by its terms, which include the length, rental rate or concessions, increase or decrease in rent, penalty for breach, default provisions, penalties for violation, obligations of tenants (like the payment of property taxes, insurance, and maintenance) as well the financial strength of each tenant. Google, for example, is a single tenant in an office that offers a 5-year term and 3% annual rental escalations. The risk profile of an office that houses 50 tenants with small attorneys, mortgage companies, and insurance companies has a significantly different one than an office that houses 50 tenants. Google's corporate stability would have enabled it to negotiate lower rates per square foot, rent increases that are lower, and terms that are more appealing than those of smaller tenants. Google's financial strength might mean that its lease represents a lower risk profile for a buyer than if it had smaller, less financially secure tenant. Strong leases, regardless of whether the asset is multifamily residential, industrial or office, can impact the property's perceived risk. It will also likely result in lower property values and a lower cap.
You need to understand financial concepts to make informed residential real property investments. There are many factors that go into evaluating potential properties. Unfortunately, there's no one-size fits all method that you can use when deciding if an investment makes sense for you. However, learning how and when to use valuation tools will equip you with the knowledge to pinpoint the best method for each prospect.
There are many ways of calculating the cap rate. However, we will only be focusing on the most common. The basic formula for calculating the cap rate is:
Capitalization rate, also called "caprate", is one common indicator of a property’s potential to be an investment. The cap rate represents the potential annual rate to return, or loss or gain on your investment.
Net operating revenue: Your gross rent income (the money you earn from renting) less any operating expenses (such a payroll and repair costs. These are the steps to get this number.
Available Capital: Although this is not a factor that affects the cap-rate of a particular property, it is something to consider when deciding on a cap rate that is "good". A general rule for commercial real estate buyers is not to use any debt or mortgages that are higher in cost (includes origination fees) and lower than the stabilized property cap rate. To buy and renovate a home, you may find it more practical to use capital with a higher cost than the cap-rate yield. Then you can refinance the debt into lower-cost debt or sell the property. If the stabilized cap rates of assets are lower than the prevailing rate for the asset, the buyer might consider borrowing less and using more capital. As the debt will reduce the property’s overall returns.