Comparing Cap Rates

In real life you may not be able to discover enough similar properties with such a narrow range of cap rates. More likely, you'll find that some properties have sold with cap rates of 5.0 to 6.0 percent (or lower) and others have sold with cap rates of 10 or 12 percent (or higher). Why such large differences?

Investors aren't just buying a quantity of future rental income. They also pay for quality. In addition, they pay for expected appreciation. Therefore the lower the quality of the income stream, and the lower the expected rate of appreciation, the higher the capitalization rate (or the higher the quality of the property's income and appreciation potential—in the eyes of the market—the lower its cap rate).

You compare two fourplexes. One is a relatively new property located in a well-kept neighborhood near a city's growth corridor. The other is located in a deteriorating part of town where major employers have moved out, closed, or laid off workers. Crime rates, too, are on the increase in this area. Two recent drug murders have been all over the local news.

If the annual NOIs for these two fourplexes are, respectively, $24,960 and $12,480, how much would investors pay for each property? If investors applied a 10 percent cap rate to each property's income stream, they would value the properties as follows:

But more than likely, investors would not apply the same cap rate to these very different properties because the quality of their income streams differs. The better-located property offers more stable rents, less neighborhood risk, and possibly greater appreciation. We might see the actual NOIs of these two fourplexes capitalized at rates of say, 7.0 percent and 12 percent, respectively.

Because most investors would rather own a property in a prospering area as opposed to a declining area, they will pay significantly more for each dollar of income produced by such a property.

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