Shouldn’t a higher cap indicate a less-risky investment?
Many online sources say a higher cap rate (NOI/Purchase Price) indicates a higher-risk investment. Why would that be true? A higher cap rate implies higher NOI compared to the asset’s market value, so wouldn’t higher NOI mean the asset would be a better investment compared to one with a lower NOI? 
The CAP rate at the commercial retail property I’m looking at is 17%. In other words, this property’s NOI is quite high compared to the property’s market value. Seems to me that the 17% is a good thing in spite of what my google searching says. …What am I missing here?
[{"id": "ih0e3w8", "text": "Cap rate can be viewed as a measure or risk, but is also the day one unleavened return on the investment. A buyer will accept a low return (cap rate) for a low risk investment like a 20yr leased McDonalds.  Unless the asset is mis-priced, a higher return is typically offered to offset the perceived risk of the investment.", "replies": [{"id": "ih0ro6g", "text": "https://m.youtube.com/shorts/j-NZpDAag98", "replies": [], "depth": 2}, {"id": "ih3e1rp", "text": "https://m.youtube.com/watch?v=vJXsW1ER5hw&amp;t=2676s", "replies": [], "depth": 2}, {"id": "ih3ga2v", "text": "Ah yes, the \u201cyeast-free\u201d return is how I measure a building\u2019s performance as well. Is that why an apartment is called a flat? \ud83e\uddd0 \ud83d\ude02\ud83d\ude02", "replies": [{"id": "ih3ixa3", "text": "Mazel tov!", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0fior", "text": "Arnt junk bonds safer? They have a higher interest rate.", "replies": [], "depth": 1}, {"id": "ih0gflt", "text": "What kind of property are you looking at?\n\nIf the tenant fails what can you do with the building?  Often things with high cap rates are reliant on that one single tenant and if he leaves you better have a good backup plan going in.", "replies": [], "depth": 1}, {"id": "ih0h4ik", "text": "Cap rates do not measure risk or return.  They measure VALUE.\n\nI doubt your 17% cap rate exists.  Someone is trying to scam you.", "replies": [{"id": "ih0pkvg", "text": "There it is!", "replies": [{"id": "ih238ag", "text": "How are all his takes terrible?", "replies": [{"id": "ih48g20", "text": "Yes. Came in here looking for his horrible takes. Was not disappointed. LOL.  If he wasn\u2019t here in here, I was tagging him because I knew he would have some garbage to throw around.", "replies": [{"id": "ih4dahl", "text": "I spent a portion of my day that I am not proud of arguing basic finance with that guy. I just am astounded that the whole rest of the world is wrong and he is right", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0hgpc", "text": "I find out why you shouldn\u2019t do deals for a living.\n\nPM me and I\u2019ll tell you why you shouldn\u2019t. \n\nEither you\u2019re getting ripped off or you hit the lottery.", "replies": [], "depth": 1}, {"id": "ih0j3ns", "text": "That cap rate is probably based on a non-stabilized, in-place income. \n\nThink a strip center with 30% vacancy and 20% below market rents or whatever.", "replies": [{"id": "ih0q5ee", "text": "Excess vacancy or below market rents will not affect the cap rate.", "replies": [{"id": "ih1jvyx", "text": "That is incorrect. Cap rate is the relationship between market value (price) and income. Excess vacancy and below market rents affect both of these factors and are typically accounted for in the cap rate when valuing a property.\n\nBelow market rents and excess vacancy both have an impact on the cap rate. Whether that be due to a decreased amount of income, a lower market value or the property being valued at a higher cap rate to compensate for the degree of risk, both do have an impact on the capitalization rate as they are directly related.", "replies": [{"id": "ih2bvxg", "text": "u/anacott27  You stated, \"\u00a0Excess vacancy and below market rents affect both of these factors and are typically accounted for in the cap rate when valuing a property\".  \n\nPlease show us the math that accounts for a difference in cap rates.  I do not believe you can accomplish what you think you can.", "replies": [], "depth": 4}], "depth": 3}, {"id": "ih1n4or", "text": "You buy the current cap rate, not the projected/stabilized rate - so it 100% if reflected in that cap as u/anacott27 said.", "replies": [{"id": "ih2c9ee", "text": "And where are you getting \"the current cap rate\"?  I'd love to see that explanation.", "replies": [{"id": "ih2ht1a", "text": "From the current NOI from the T12; divide by purchase price.", "replies": [{"id": "ih2i5nh", "text": "Where are you getting the \"purchase\" price?", "replies": [{"id": "ih2iiv8", "text": "Do a DCF with your assumption - yes that purchase price is indicative of low vacancy etc. However, you a placing your current NOI over that assumed stabilized price.", "replies": [{"id": "ih2makk", "text": "Then where are you getting the discount rate?  At best you are getting a VALUE, not return for you but if your expectations are whack your value will be also.", "replies": [], "depth": 8}, {"id": "ih2n2zq", "text": "\"However, you a placing your current NOI over that assumed stabilized price.\"\n\nWhat do you think this number tell you?  If the property is capable of producing $100,000 NOI but is only currently only producing $50,000 how is your calculation helpful...what if it was only producing $25,000?  See, that calculation is meaningless.", "replies": [{"id": "ih2nsb4", "text": "I agree - cap rates are meaningless values. Most people in the industry would agree, but it\u2019s a metric/gauge of what the cost of a $1 of NOI is.\n\nMost people prefer to look at stabilized/projected NOI for Caps but that has even more assumptions that cause even more problems.\n\nThe reason to show both is to show there are operational issues (ie higher expenses, missing market rents, etc) that can be corrected to boost NOI.", "replies": [{"id": "ih2pd60", "text": "I never said cap rates are useless.  I said your calculation was useless.  \n\nIf 2 similar properties have $50,000 NOI and market cap rates are 10% then you are saying both properties are worth $500,000.  V=i/r.  But one property is stabilized and the other is not and is capable of producing $75,000 NOI.  What does your calculation tell us?  Obviously the second building is worth more but your calculation incorrectly tells us they are worth the same.", "replies": [{"id": "ih2r7pj", "text": "Aka why I said why cap rates are useless - and why I said investors look at stabilized caps if you are talking about broad trends. You look at unstabilized to see where the property is at and see what someone else says you can stabilize too IF their assumptions are true.\n\nMost real investors don\u2019t even look at Cap Rates for these very reasons.", "replies": [{"id": "ih2scub", "text": "\"Most real investors don\u2019t even look at Cap Rates for these very reasons.\"\n\nThere is a billion dollar industry that analyzes closed sales to calculate and report cap rates.  Real investors are very interested in cap rates and their possible change because cap rates tell you the probable market value based on cap rate comps.", "replies": [{"id": "ih2toka", "text": "Yes in a broad sense over a large number of transactions - it is a gut-check / gauge. On the property level people like to see it, but decisions are made by looking at Cash/Cash, IRR, or LIRR - not Cap Rates.\n\nI\u2019ve done several billon in transactions at this point myself so feel pretty confident in saying no one puts to much weight behind a cap outside of the market level unless those other key values are significantly off.", "replies": [{"id": "ih2uukg", "text": "You are confusing cap rates which come from an income approach to value called direct capitalization with CoC, IRR, etc. which are return metrics.  \n\nThey do different things.  Once you use direct capitalization to get the probable market value THEN you can use return metrics.  \n\nHow can you calculate a return when you don't have a value?  That is where you are off track.", "replies": [], "depth": 14}], "depth": 13}], "depth": 12}], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0kow1", "text": "More risk more return. More risk higher cap rate.", "replies": [{"id": "ih1mqf3", "text": "Aka no free lunch", "replies": [], "depth": 2}], "depth": 1}, {"id": "ih0m8nf", "text": "Crazy how many people in this industry don\u2019t understand basic finance", "replies": [{"id": "ih29p54", "text": "To be fair, OP isn\u2019t representative of the majority of people making money in the industry.", "replies": [{"id": "ih2a99v", "text": "I think a lot of amateur investors whose deals penciled solely due to the 10yr bull market are in for a very rude awakening in the next 18 months", "replies": [{"id": "ih2aq7g", "text": "Why is my 12 cap retail center failing? 70% of my tenants defaulted?", "replies": [{"id": "ih2z14d", "text": "Bigger number more better than littler number.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0m8wv", "text": "Multifamily cap rates are 4%. Why is that? Isn\u2019t Multifamily less risky than say a big box retail center with a non credit tenant? Lower risk means lower return.", "replies": [{"id": "ih0r1un", "text": "Cap rates can be indicative of risk but do not measure risk.", "replies": [{"id": "ih2hpxa", "text": "That is correct", "replies": [{"id": "ih2nl30", "text": "Cap rates should reflect investor/capital markets appetite reflective of asset quality/tenancy. In your case MF has non binary vacancy (multiple units) and short term leases which will reset at end of lease (1 year). Retail is concentrated risk with long leases. The discount rate should capture all risks to your cash flow to achieve your expected return.\n\nA discount rate will always be higher then the cap rate as long as income growth is positive.", "replies": [{"id": "ih2qwwa", "text": "Yes that is true", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0oimu", "text": "Paging Dr Bob, Dr Bob to this thread please.", "replies": [{"id": "ih3e8cr", "text": "https://m.youtube.com/watch?v=vJXsW1ER5hw&amp;t=2676s", "replies": [], "depth": 2}], "depth": 1}, {"id": "ih0pezp", "text": "Try using a direct comparison approach, that could help you understand if the asset is undervalued", "replies": [{"id": "ih0r8dk", "text": "If a property is encumbered with above/below market leases you cannot value using sales comparison.  This is the reason direct capitalization income approach would be used.", "replies": [{"id": "ih19k9l", "text": "Sure you can. Just adjust for excess/deficit rent just as you should in a direct cap. The encumbrance isn\u2019t going to exist in perpetuity.", "replies": [{"id": "ih2dc22", "text": "Cap rate is a one year snapshot of value.  It was not designed to measure perpetuity.   Identical properties, one stabilized and one vacant will trade at the same cap rate.  \n\nHow would you mathematically show different cap rates?  I don't think you can.", "replies": [{"id": "ih4spgt", "text": "&gt; Identical properties, one stabilized and one vacant will trade at the same cap rate. \n\nHow do you account for the difference in price between the stabilized property and the vacant property?", "replies": [{"id": "ih4vdma", "text": "Good question!  Probably most of you with little commercial real estate experience will perhaps have an understanding of ARV for small residential properties.   You want to know what the market value will be after all your fixing so you end up with profit.\n\nPretty much the same concept in direct capitalization to get the value after you work to stabilize.  Say the stabilized property next door is selling at a 5 cap and the stabilized NOI is $100,000.  V=i/r. $2,000,000=$100,000/5%.\n\nYour identical property next door will be worth $2,000,000.  But once you have the 2mil you need to make below the line adjustment for the lost rents.  You would figure out how long to stabilize and deduct the NPV of the lost rents and subtract from 2mil.  Then there are lease up costs and those would be deducted.  Then there is a risk component that would be negotiated and deducted from the price.  \n\nSo both buildings can be worth $2,000,000 but the vacant one has expenses to get there that would be accounted for in below the line adjustments.", "replies": [{"id": "ih513xf", "text": "But that means the vacant one is worth less than $2M, and it is for the same reasons that a fixer-upper is worth less than ARV (to extend your comparison to residential flipping). If the below the line adjustments bring its value down to $1.6M, then that is the same as a 6.25% cap rate based on the projected $100k NOI; knowing you'll have to spend more to get it to stabilization. If it isn't vacant but rented below market, then maybe it will trade at $1.82M (the $2M minus below the line adjustments). That'd be 5.5% cap rate based on the projected $100k NOI. If the below market in-place rents are kicking off $80k NOI, then it's 4.4% cap rate based on those in-place rents; knowing it'd be $2M at stabilization with $100k NOI.", "replies": [{"id": "ih53mlh", "text": "I showed you how both properties are worth 2mil.  The vacant property just has expenses to get to stabilized NOI!  Cap rate measures the value of NOI.  NOI starts with PGI.  This property has the EXACT SAME PGI as the stabilized property.  Your calculations based on in place NOI are meaningless.  \n\n1.  How did you get the V in your crap rate calculations?  \n\n2.  Were you buying $0 NOI or the probable $100,000 NOI?  \n\n3.  Your figures make no sense.  Please explain how you got each number you posted like I did.", "replies": [], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0u63w", "text": "A 17% cap rate, if it existed, would mean the seller is willing to take $5.88 for each possible dollar of NOI.  A 5% cap would mean a seller would expect you to pay him $20. \n\nStill think that 17% is your \"return\"?", "replies": [], "depth": 1}, {"id": "ih0ujdu", "text": "Think of \"risk\" &amp; \"investor interest\" as inversely correlated concepts &amp; remember that $1 of NOI = $1 of NOI.\n\nThe income generated by an apartment in a hot MSA is going to be significantly more stable than a strip retail center in rural Ohio that has struggled to maintain &gt;50% occupancy. Therefore, an investor would be willing to value the stable NOI of the apartment at a 4% cap vs a hypothetical 17% cap on the \"stable\" NOI of the strip retail. \n\nIf a tenant moves out of the apartment, a replacement tenant can be found in a matter of days, and paying rent in a couple of weeks. The risk of losing that NOI is minimal.  \n\n\nIf the legacy nail salon in a town with negative job growth takes up 20% of a property &amp; decides to shut their doors / not renew, that space could sit vacant indefinitely. That NOI could be gone for good.", "replies": [{"id": "ih1yo7v", "text": "u/mill40 To add to this. If value is a sum of the present value of future cash flows the risk of those future cash flows going to zero reduces value.\n\nCap rate compares value to current cash flow but value falls if the risk of future cf is higher.\n\nExample\n\nCf today $50 for a and B where A is a risky investment whose future cf are discounted by 20% each year and B is a riskless investment with no discount. For simplicity we will ignore inflation and all other components of the discount rate.\n\nA: $50/ ($50 + $50/(1+.20)) = 54.5% cap rate\nB: $50/ ($50 + $50/(1.00)) = 50% cap rate\n\nI use only two periods here because I am typing on a phone but obviously if you extend this out enough years you would get more normalized cap rates and can clearly see that risk lowers value by making future cf less reliable but because the numerator is fixed in this example the less risky investment has a tighter cap rate. All else equal a mf property and a hotel with the same cf will trade at dramatically different valuations.", "replies": [{"id": "ih2fsp5", "text": "\"A: $50/ ($50 + $50/(1+.20)) = 54.5% cap rate B: $50/ ($50 + $50/(1.00)) = 50% cap rate\".\n\nThat is not a cap rate!  The formula is r=i/v.", "replies": [{"id": "ih2osmq", "text": "$50 is income in this example. The term on the other side of the division sign is the sum of a series of cash flows discounted to the present day, aka value (finance 101)once calculated. So that is a cap rate", "replies": [{"id": "ih2q6mq", "text": "Are you trying to say DCF is the same as cap rate?  That is 100% incorrect.  Cap rate formula is  r=i/v.  If you have the V you are wasting time trying to calculate a cap rate.\n\nAlso where are you getting the discount rate?", "replies": [{"id": "ih2vf3n", "text": "I am saying that DCF can be used to arrive at value, value is one of the variables used in the cap rate formula, the other being income. Value = DCF. Cap rate = income/ value (which equals DCF).\n\nThe point of the exercise is to demonstrate how risk enters the equation. Risk modifies the discount rate of a dcf by changing the probability of receiving the future cash flows upon which DCF relies. Higher risk lowers the value of future cashflows not yet received and thus lowers value. It follows then that because cap rate is equal to income / value and a property with higher risk for the same level of cf will have lower value the result then is that cap rates will be wider for riskier assets. \n\nIf the previous statement is true then cap rates by necessity tell us something about the level of risk market participants are assigning to an asset and therefore cap rates are among other things a measure of risk purely as a result of how their component pieces are in turn constructed. That doesnt mean they only measure risk but it does mean that they also measure risk and some information about relative risk is available just reviewing market cap rates.\n\nRegarding where I am getting the discount rate; The discount rate is usually risk free rate + risk premium + cost of financing. For this example I ignored all aspects of the discount rate except for risk and created an extremely high discount rate in order to highlight just the effect of risk in isolation for a 2 period cf stream because I am typing on my phone.", "replies": [{"id": "ih342p4", "text": "Risk, cap rates can be indicative of risk but do not measure risk.  Class A office in Philly trades at 7%.  In SF it trades at 4%.  I say the risk is about equal but you are saying Philly Class A is almost TWICE as risky!  \n\nSo where did you get the \"risk\" component for your DCF since the other components would be basically the same in SF and Philly?  \n\nSee, cap rates do not measure risk.  \n\nNow why are they selling at different cap rates if the risk is probably the same?\n\n1.  Anticipated different rent growth would be a reason, or\n\n2.  It could be as simple as Philly rents being one quarter of SF.  Since NOI does not account for capex then each dollar of NOI in Philly has to cover 4sf where in SF it only covers 1sf.  Now think of all the capex based on sf.  \n\nThese 2 items are the probable reason for the difference in cap rates, not risk.", "replies": [{"id": "ih37fjd", "text": "You have that backwards. The class A in philly is indicated as more risky as shown by the wider cap rate. Of course the risk is not the same, far easier to backfill after a lost tenant for a office building in SF than it is in Philadelphia.  I agree with you that there is of course in the cap rate some information about expected growth rates. That is why in my example we assume the cf is the same $50 every year so growth assumptions dont muck up the example. That assumption covers both your points 1 and 2. We focus purely on risk to demonstrate the effect of risk in a vacuum. \n\nAs for where I got my risk estimate, I would repeat that I made it up to demonstrate the point.", "replies": [{"id": "ih3coki", "text": "No, the spread in cap rates is not a measure of the risk.  Class A office in both cities have about the same vacancy rate.  \n\nAs I stated the cap rates measure the difference in the value that investors are willing to pay for NOI.\n\nSome of that difference may be attributable to risk but you cannot quantify it by the cap rate.   \n\nA good argument could be made that the SF NOI is riskier since investors have bid up the NOI value to $25 and can rents go any higher?  \n\nAs far as your risk premium I was asking where you got it irl. I showed you how the cap rates will give you the value to the penny.  Please show me how to get a reliable risk premium.", "replies": [{"id": "ih3eyew", "text": "I agree that cap rate can show you the difference in value that investors are willing to pay for NOI. I am just curious why you think risk has no bearing on that value.", "replies": [{"id": "ih3ial5", "text": "I have repeatedly stated that cap rates can be indicative of risk but they do not MEASURE risk.  They measure value.  \n\nI showed you in my Philly example that the 3 point cap rate difference probably has more to do with capex and rent growth.  No one is going to say Philly is 75% riskier.", "replies": [{"id": "ih3l3op", "text": "Its a half dozen one way 6 the other. You're talking in circles. Risk is a component of value because valuation relies on estimates of risk. That is finance 101. If you hold all other components of value equal what you are left with is relative estimates of risk. Your cap rate holding all other elements of value equal and cf equal by nature then reflects risk.\n\nIf you told me that you are selling an apartment complex across the street from my hotel and your complex had the exact same cf as my hotel with the same proforma future cfs and the same estimates of future growth rates and all other components of valuation I would buy your apartment complex and ask to see the rest of your portfolio.", "replies": [{"id": "ih3wciv", "text": "A hotel and a multifamily can have the exact same NOI's but sell at different cap rates.  They are different asset classes and have different supply and demand which determines the cap rate.  That is what cap rates do, measure the VALUE of NOI to the market.", "replies": [{"id": "ih43dlf", "text": "Ok", "replies": [], "depth": 14}], "depth": 13}], "depth": 12}], "depth": 11}], "depth": 10}, {"id": "ih4mt9d", "text": "Agreed that cap rates are not a rate of return. \n\nCap rates are indicative of both risk and expected rent growth. They are quite literally the inverse of a PE ratio for stocks (which are also indicative of risk and growth). \n\nIf investors believe rents will grow, this will put downward pressure on cap rates and make every marginal dollar of NOI more expensive (because they expect more NOI in the future). Conversely, if investors expect rents to fall, cap rates will rise because investors will expect to pay less per marginal dollar of NOI. \n\nRisk is related to investors\u2019 expectations about future NOI, not just current vacancy rates. Investors expect SF to be less risky (read: rents have a higher chance of being high) because of its proximity to the second largest concentration of capital in the country (Silicon Valley) and because it\u2019s hard af to build new in SF. \n\nHere\u2019s the caveat\u2014 while cap rates do not measure return, your cap rate at purchase is essentially your expected yield 1 moment after purchase. If you don\u2019t expect your rent roll to change much, your going in cap rate will approximate your unlevered yield.", "replies": [], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}, {"id": "ih358vy", "text": "Value, a cap rate will tell you to a penny what other investors have paid for NOI.  $10 in a 10% cap and $20 in a 5% cap.  If a reliable source of cap rate comps reports 9.9%, 10% and 10.1% then I would expect to pay about $10 for NOI.  The problem with DCF is the \"risk\" component that would be a wag for most investors.", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih0ygrz", "text": "The more you pay, the less your return and the more you pay for a property typically reflects the safety net a property offers. For example, a property that has a 10 year lease with a blue chip lease covenant (strong tenant) means an investor would be willing to pay more so as to not have to worry about long lease up periods etc.", "replies": [], "depth": 1}, {"id": "ih1g5f9", "text": "At its most basic, a buyer should be willing to pay a cap rate that represents their cost of capital plus a risk adjusted increase.  The more risk in the deal the higher the cap rate goes.\n\nAs a buyer a higher cap rate reduces your risk exposure, so from the buyers perspective I guess you can say a higher cap rate equals lower risk (for the buyer), but from the markets perspective the difference between the cap rate and the risk free rate represents the amount of risk in the deal.", "replies": [], "depth": 1}, {"id": "ih1h85o", "text": "An extreme illustration:\n\n2% cap strip mall. Tenants are Macy\u2019s, Red Robin, and AMC, all with years left on their lease. \n\n11% cap strip mall. Tenants are a chop shop, a psychic\u2019s office, and a vacant building because it was the site of a Satanic sacrifice. But don\u2019t worry, Dirty Mike and the Boys have moved in, they\u2019re not moving out, and they pay you in bodily fluids of all kinds they leave on your sidewalk.\n\nWhich one is riskier? If you were investing your mothers money, which one would you buy?", "replies": [{"id": "ih1mu7k", "text": "A bit outdated \u201ccredit tenants.\u201d Macy\u2019s and AMCs are shuttering when their initial term runs out all over the country unfortunately.", "replies": [], "depth": 2}], "depth": 1}, {"id": "ih1lbq5", "text": "Ayyayayay", "replies": [], "depth": 1}, {"id": "ih1ocli", "text": "There has to be something you\u2019ve missed. Nobody sells a property at a 17 cap price point. Almost nothing available that is desirable even offers half that return. \n\nIs the 17% hypothetical based on \u201cif it\u2019s 100% leased or if you tear it down and rebuild and then lease it out\u201d? It could be that they\u2019re selling a business and a property with a 17% cap rate including the profit from running the business (car mechanic etc).   \n\nAlways read the fine print!", "replies": [], "depth": 1}, {"id": "ih22rc5", "text": "No, risk free are T-Bills so the closer the rate is to that the \u201cguarantee \u201c the cash flows.", "replies": [], "depth": 1}, {"id": "ih2cx7q", "text": "Reading through your message, you wrote \"A higher cap rate implies higher NOI compared to the asset's market value.\" \n\nA different way of looking at it is the CAP rate is used to derive the asking price, not the other way around. \n\nFor example, if you are looking at an updated apartment complex with a $100k NOI in the Silicon Valley, the risk of vacancy and not earning that NOI is very low. Lower risk means a seller can offer a lower cap. Let's apply a 4% cap to it and the asking price is $2.5 Million for that asset producing $100k NOI. \n\nNow compare that with a rundown strip center with a bunch of mom-and-pop, non-recession proof, month-to-month cash paying tenants in a small rural town. Let's say that center also produced $100k NOI. However, the risk of actually receiving that NOI is higher. Vacancies take longer to fill, tenants are more likely to default, etc. For an investor to choose to put their money there, it needs to be more attractive and offer a higher return (maybe in this case an 8% cap) to offset that risk. So for that $100k NOI produced by this property, an investor might only be willing to pay $1,250,000.", "replies": [], "depth": 1}, {"id": "ih3cm1a", "text": "A cap rate is derived from the concept of perpetual bonds: the owner of the bond pays a certain amount money upfront for the bond and subsequently receives cash flow, in the form of an interest payment, for as long as they own the bond. The yield of the bond is cash that returns to the investor (as a percentage) in the form of interest.\n\nThe formula to calculate the yield is: Current Yield = Annual Interest Paid / Market Price of Bond\n\nThe general formula for a cap rate is *Cap Rate = Annual NOI / Value of Real Estate. *Note that for this formula to work for real estate, we need to put cash aside every year to extend the life of the asset. Here, the industry assumes CAPEX is equal to depreciation, offsetting above the line and below the line expenses.\n\nA cap rate is essentially a perpetual bond formula for the real estate industry. It's important to note there are couple different types of cap rates out and each has its own specific use.\n\nReported Cap Rate = Cap Rate Reported by Seller/Buyer/other party to transaction. When looking at comparable properties, this can help guide estimated value of the property using the Income Comparison Approach.\n\nEstimated Going-in Cap Rate = Yr 1 NOI, under your ownership/ Purchase Price. This helps establish a baseline when looking at your terminal cap rate during underwriting.\n\nTerminal Cap Rate = Terminal NOI (first yr of NOI after your ownership / expected sales price). The Terminal Cap Rate is used to estimate the resale value of the property beyond the projection period in a discounted cash flow model.\n\n\nOne follow up on cap rates.\n\nA cap rate, similar to yield, is the markets signal of implied risk.\n\nExample: Apples S&amp;P credit rating is AA+ and yields a ~2.64% whereas Netflix\u2019s credit rating is B+ \u201cjunk\u201d and yields ~6.4%.\n\nSimilarly Class A infill apartments in the US trade at 4.65% cap rates vs Class C suburban apartments trade at 6.24% cap rates (per CBRE\u2019s 2018 2nd half cap rate survey).\n\nSay that you have 2 apartment buildings that both generate 100,000 in NOI. One is Class A Infill and the other is Class C suburban.\n\nClass A Infill: 100,000/4.65% = $2.15M value\n\nClass C Suburban: 100,000/ 6.24% = $1.60M value\n\nWhile the properties generate the same amount of NOI, investors are willing to take a lower yield because the implied risk is less in a Class A infill location vs a Class C suburban location. In other words, the Class A Infill apartment\u2019s 1.59% lower cap rate creates 550,000 more in value than the Class C suburban apartment \u2014 all because investors feel more confident of future NOI.\n\nThat said, by understanding what cap rates are of comparable properties in the market, you can quickly see if the deal you\u2019re underwriting is generating similar yields to the market. If there is a disconnect, your job is to tease out what is causing the discrepancy (ex below market rents, below market expenses, deferred maintenance, etc) and take that into consideration in your underwriting.\n\nThe next step would be to evaluate whether you feel that cap rate on your investment will move during your hold. To compress cap rates, you can evaluate whether it makes sense to do value add work to convert it to a nicer product and raise rents, assuming there is demand. Additionally cap rates can compress as a neighborhood begins to gentrify as more investment is flowing into the neighborhood and investors are comfortable with a lower yield. The latter is very hard to determine and is never taken into consideration in our terminal cap rate.\n\nTLDR: Cap rate = Implied Risk", "replies": [{"id": "ih447yg", "text": "Going in cap rate is a myth and a waste of time trying to calculate.  Now you need the Value to calculate a cap rate.\n\n1.  How did you get that value?\n2.  What exactly did you buy?\n3.  What does that useless number tell you?", "replies": [{"id": "ih5aksa", "text": "Which cap rate? Going in? As-is value? Stabilized? Each one is trying to sell you a story", "replies": [{"id": "ih5cumu", "text": "Any one other than stabilized.  Eh, let's start with going in since I had a thread that no one was able to explain.  \n\nWhat is a going in cap rate and what does it tell you?", "replies": [{"id": "ih6oojn", "text": "Implied Cap rate is the Implied yield based on in place cash flow and your purchase price with the assumption noi stays the same for perpetuity \n\nThe cap rate here helps you compare the yield of the subject property against comps that recently sold in the market. By comparing the yield of the subject property against comps you can begin asking questions around why the yields are different. If cap rate (yield) is higher than comps, its more risky. Once you figure out why, then you ask yourself whether you are capable of managing the risk and whether you are fairly compensated for the level of risk you may be taking.\n\n\nGoing in cap rate is equivalent to a P/E ratio for publicly traded stocks. The only difference is that the numerator and denominator are flipped in the calculation. The purpose of cap rate and p/e ratio is the same - valuation and to find out whether they are overvalued or undervalued.", "replies": [{"id": "ih7r0hl", "text": "You stated, \"Going in cap rate is equivalent to a P/E ratio for publicly traded stocks. The only difference is that the numerator and denominator are flipped in the calculation. The purpose of cap rate and p/e ratio is the same - valuation and to find out whether they are overvalued or undervalued.\"\n\nGoing in cap rate=i/v\n\n1.  What NOI are you using?\n\n2.  How did you calculate the V?\n\n3.  What does this number tell you?", "replies": [{"id": "ih7s2rr", "text": "It shows me the solution to the equation", "replies": [{"id": "ih7t78x", "text": "But are you just interested in simple math solutions or actual useful metrics?\n\nIf you can't quantify the NOI or explain how you got the V or what the rate is telling you then you just wasted your time and are probably getting scammed.", "replies": [{"id": "ih818rp", "text": "I\u2019m ok, thanks for offering!", "replies": [{"id": "ih85840", "text": "I'm not offering anything.  You were going to explain going in cap rate.  It seems obvious you dont know what you are talking about.  \n\nQuit wasting time.", "replies": [{"id": "ih87r7y", "text": "Look at the thread above (and the countless comments i\u2019ve posted to your previous comments). Let\u2019s agree to disagree. Seems that both views are working out for us in our own special ways.", "replies": [{"id": "ih88nvh", "text": "No, you jumped in and made a statement of what you can do but then failed to answer basic questions about your statement.  \n\nOver promised and under delivered.\n\nMy statement is that you can't answer my basic questions because you don't know what you are talking about and now you are trying to weasel out.\nu/grac43,  at least the other poster deleted his post when he realized he was in over his head.", "replies": [{"id": "ih8dkvm", "text": "We\u2019ve already done this song and dance and my arguments have not changed. Happy reading!\n\n\nhttps://www.reddit.com/r/CommercialRealEstate/comments/u1iutb/how_long_does_it_take_to_learn_cre_financial/?utm_source=share&amp;utm_medium=ios_app&amp;utm_name=iossmf\n\nhttps://www.reddit.com/r/CommercialRealEstate/comments/n35ttz/does_a_higher_cap_rate_always_mean_its_a_better/?utm_source=share&amp;utm_medium=ios_app&amp;utm_name=iossmf", "replies": [{"id": "ih8f3sh", "text": "I am not arguing with you.  I asked you to clarify your going in cap rate calculations.  \n\nHow did you get that value?What exactly did you buy?What does that useless number tell you?\n\n3 simple questions.  \n\nShould take you less time than all your cutting and pasting.  \n\nCan you answer or not?", "replies": [], "depth": 14}], "depth": 13}], "depth": 12}], "depth": 11}, {"id": "ih94g07", "text": "Here is the definition of going in cap rate per the commercial real estate finance counsel \n\nhttps://www.crefc.org/cre/content/learn/Glossary/CREFC_Glossary.aspx?WebsiteKey=105b6c32-4dc8-4e9f-8ba4-8b92bdce1c9e&amp;hkey=73766de8-5900-480d-a0f3-b4e75bd3ed84&amp;GlossaryTabs=7#GlossaryTabs\n\n\nAnd cap rate\n\nhttps://www.crefc.org/cre/content/learn/Glossary/CREFC_Glossary.aspx?WebsiteKey=105b6c32-4dc8-4e9f-8ba4-8b92bdce1c9e&amp;hkey=73766de8-5900-480d-a0f3-b4e75bd3ed84&amp;GlossaryTabs=3#GlossaryTabs\n\nAnd reversion cap rate\n\nhttps://www.crefc.org/cre/content/learn/Glossary/CREFC_Glossary.aspx?WebsiteKey=105b6c32-4dc8-4e9f-8ba4-8b92bdce1c9e&amp;hkey=73766de8-5900-480d-a0f3-b4e75bd3ed84&amp;GlossaryTabs=18#GlossaryTabs", "replies": [{"id": "ih976d4", "text": "None of that answers the 3 basic questions I asked you.\n\nCan't you answer them?\n\n\nGeez, what scammers!  Their definition of going in cap rate,  the capitalization rate applied to the first years income!!!!\n\nSeems your source doesn't even know what NOI is.  Pathetic!", "replies": [{"id": "ih9ceqe", "text": "Cap rates in principle can only rely on future cash flows. The value is derived from the sum of all of the future noi in perpetuity discounted back by the cap rate. This gets you to todays value.\n\nMore simply said You wouldn\u2019t use the t-12 NOI because you do not own the asset and you are not entitled to the NOI", "replies": [{"id": "ih9g16u", "text": "It is the NOI that you are buying.  A capitalization rate tells you what other investors have paid for NOI of similar properties.\n\nThe day you close the NOI is yours.  WTF are you going on about?  What NOI  and cap rate are you using?  \n\nBut back to my original 3 basic questions please.  LOL", "replies": [{"id": "ih9gug7", "text": "I can\u2019t buy historical NOI.\n\nI would need to figure out what my NOI would be. This means I would need to calculate MY NOI when the property is in MY hands.\n\nI would then look at the buyers sale price.\n\n\nDivide MY NOI to their Purchase Price to get a cap rate.\n\nThen i would look at that cap rate and ask myself, is their price fair when looking at comp sales.\n\nIf yes, then do full blown underwriting to see what price im willing to pay.", "replies": [{"id": "ih9mwre", "text": "You are deflecting.  Three basic questions!", "replies": [], "depth": 16}, {"id": "ih9ng4b", "text": "Why would you waste time trying to calculate a cap rate?  And why would you use their asking price?  That is not what investors do.", "replies": [{"id": "ih9qu0d", "text": "Let me give u an example from today.\n\nBorrower reached out to me saying he\u2019s looking to refi a loan with us which we originated 7yrs ago. \n\nHe tells me that he got an offer for the retail strip center last yr for 9MM (fully stabilized property).  The last appraisal from 7yrs ago had a value of 6MM\n\nUnder the loan he is required to report annual financials and in 2021 the property was 95% occupied and had an NOI of 585,000\n\n9MM value / 585k NOI = 6.5% cap rate. \n\nThat 6.5% cap rate is GENERALLY within the range stabilized non anchor strip centers trade, meaning, ok his number isnt BS.\n\nComfortable with the 9MM value, the  LTV based on the 4.5MM loan request is 50%.  Ok cool \n\n\nLOI goes out\n\nLoan amt equal to the lesser of\n\n4.5mm\n\n50% as is LTV based on appraisal engaged by lender\n\nLoan which supports a 13% debt yield based on as is noi based on appraisal engaged by lender", "replies": [], "depth": 17}], "depth": 16}], "depth": 15}], "depth": 14}, {"id": "ih9n887", "text": "So how do you discount the sum of the future NOI by a cap rate?", "replies": [{"id": "iha5amx", "text": "You don't?", "replies": [{"id": "ihhkben", "text": "This is what u/grac43 stated,  \"The value is derived from the sum of all of the future noi in perpetuity discounted back by the cap rate. This gets you to todays value.\"\n\nSo you are saying this is incorrect?", "replies": [{"id": "ihhzxkk", "text": "In this example (going in cap rate) -&gt; 1st yr NOI divided by cap rate\n\nV=i/r", "replies": [{"id": "ihidelj", "text": "You seem to be going in circles.  How did you calculate first years NOI?  Where did you get the cap rate?", "replies": [{"id": "ihifb2q", "text": "R = V/I\n\nValue = price of asset  (asking / your counter offer / their counter offer / final purchase price)\n\nI = underwritten income during first year of ownership\n\nR = cap rate!\n\nDidn\u2019t we go through the multiplication and division properties of equality help to solve algebraic equations involving real numbers earlier this week? \n\nR = V/I\n\nIS EQUAL TO\n\nV = I/R\n\nIS EQUAL TO\n\nI = R * V", "replies": [{"id": "ihig2ni", "text": "1.  But if you anticipate \"your\" NOI to be higher than the sellers you are overpaying him!\n\n2.  If you determine \"value\" by the sellers asking price you are probably overpaying him!", "replies": [{"id": "ihiig2u", "text": "You\u2019re exactly right, which is why you do a lot of due diligence to get as close as possible to the \u201cright\u201d variables. That\u2019s the art of underwriting.", "replies": [{"id": "ihijoya", "text": "But you are using all the wrong inputs.  What art are yiu using, paint by numbers?", "replies": [{"id": "ihimbjz", "text": "There are no right numbers. The best you can do is make well informed predictions of numbers. We can only predict the future. The past is the past.\n\nUnless we\u2019re talking abt a pure NNN lease, last yrs NOI is rarely if ever going to equal this yrs NOI, let alone this yrs budget", "replies": [{"id": "ihinnu0", "text": "Made up numbers are not an art.  It is just bad investing.\n\nSo you dont want to use the sellers historic expenses but jump at the chance to use his \"asking\" price which is probably based on his historic NOI!  GEEZ", "replies": [{"id": "ihiqamc", "text": "I feel insulted by your comment. You don\u2019t think looking at historical NOI would help me make an informed projection of YR1  NOI?\n\nMaybe you just don\u2019t understand what making an informed projection means?\n\nAnyway\n\nUnderwriting to strictly historical numbers is down right negligent- inflation / lease rollover / taxes/ fraud/misrepresentation/ etc etc\n\nHistorical\u2019s only show the sellers expenses. You need to figure out YOUR FUTURE anticipated expenses based on DUE DILIGENCE!\n\nDID I TEACH YOU NOTHING GRASSHOPPER!!!!\n\nWe underwrite first yr NOI under our ownership and calculate cap rate as such.\n\nR = I /P\n\nWe have one variable that is his (purchase price which has his NOI baked in as you mentioned) and one value that is ours (1st yr Underwritten NOI).\n\nThe result, a cap rate, gives us a baseline in which to compare, contrast, negotiate, etc. Similar to purchase price on a $/sf its just another measurement in which to evaluate the opportunity against comps in a way that it\u2019s apples to apples.\n\nAgain just a baseline for comparison, its not telling your return on the investment.", "replies": [{"id": "ii7kgpu", "text": "Sorry if you\u2019re triggered", "replies": [], "depth": 26}, {"id": "ij7xw4j", "text": "Again, not a rate of return metric.\n\nhttps://m.youtube.com/watch?v=T1APlX0vqSU&amp;t=633s", "replies": [{"id": "ijg0jr4", "text": "Mike S Glaspie's video was intended to clear up any \"confusion\" around cap rates when in fact he makes one of the most common mistakes when calculating cap rates - including below the line CAPEX. His video is talking about cash on cash return with is a more suitable metric when evaluating value-add strategies since the cash coming in and going out is more variable due to lease up and CAPEX strategies.\n \n1) The first minute just explains multiplication and division properties of equality help to solve algebraic equations. This is simple math. With NOI held constant, higher cap rate -&gt; lower value, lower cap rate -&gt; higher value\n \n2) From 11:05-11:09 he states the cap rate \"the cap rate will go down, losing value over the period of 7-10 years\". This is inconsistent with algebraic equation above.\n \n3) From 11:19-12:06 he goes into why the \"value will go down because the property is not in the same condition it was when you purchased it\"- due to the cost of maintaining the property which includes roof replacement, hvac, electrical. This statement is misleasing - the value isn't going down, the sponsor's basis is going up which impacts the sponsors cash on cash return. Again, CAP Rates only work on stabilized properties - otherwise it's misleading. \n \n \nA cap rate is derived from the concept of perpetual bonds: the owner of the bond pays a certain amount money upfront for the bond and subsequently receives cash flow, in the form of an interest payment for as long as they own the bond - the yield of the bond is cash that returns to the investor (as a percentage) in the form of interest. *Note that for this formula to work for real estate, we need to put cash aside every year to extend the life of the asset. Here, the CRE industry assumes CAPEX is equal to Depreciation, offsetting above the line and below the line expenses. By having CAPEX equal to Depreciation we're symbolizing that the sponsor is putting in the minimum amount of capital to keep the property STATUS QUO to keep NOI the SAME.\n \nTLDR: Mike S Glaspie is confusing cash on cash return and cap rate.", "replies": [], "depth": 27}], "depth": 26}], "depth": 25}], "depth": 24}], "depth": 23}], "depth": 22}], "depth": 21}], "depth": 20}, {"id": "ihih846", "text": "There is nothing wrong with the formula.  The problem is you inputs.\n\nV=sellers asking price?  WRONG\nI= your better than sellers NOI?  WRONG\nR=  Using bad inputs gets you crap rate!", "replies": [], "depth": 20}], "depth": 19}], "depth": 18}], "depth": 17}], "depth": 16}], "depth": 15}], "depth": 14}], "depth": 13}, {"id": "ih9fo1b", "text": "Also because there is an equal sign in the formula it indicates equality between the two sides. This means the formula can be manipulated while performing valid operations on both sides of the equation such that it remains a true statement.\n\n Because of this, the formula for cap rate - (income/value = cap rate) can be rewritten to\n\nValue = income/cap rate\n\nAnd\n\nIncome = value * cap rate", "replies": [{"id": "ih9gk7x", "text": "OMG!  Did you just learn IRV?  But back to my 3 basic questions......", "replies": [{"id": "ih9i6sf", "text": "What are they again? \n\nAlso, can you include your responses?\n\nLoving this discourse", "replies": [{"id": "ih9pbp9", "text": "Going in cap rate!  What NOI are you using, where are you getting the value in the calculation &amp; how would you use it?", "replies": [{"id": "ih9sagq", "text": "Noi is first yr noi under my ownership (taxes get re assessed here upon a change in ownership which will impact my noi)\n\nValue - asking price \n\n\nWhat do i do with cap rate? Probably spend 5 min asking myself if the asking price is BS\n\nIt\u2019s really just a baseline to kick off a decision tree around what questions to ask myself/ seller/ broker etc.\n\nOnce deal is a go i dont feel the need to revisit it; we do a full dcf to come back with a our asking price. That asking price and 1st yr noi creates a going in cap rate. I use that cap rate as a baseline for my exit price is my exit cap higher or lower? Why? What\u2019s my thesis. It\u2019s all theoretical to sell the story.", "replies": [], "depth": 17}], "depth": 16}], "depth": 15}, {"id": "ih9m8dl", "text": "I explained the inequality because i feel like your argument disregards the formula cap rate = noi/value which is equal to NOI = cap rate * value\n\nWith value held constant the higher the cap rate, the lower the value\n\nThe lower the cap rate, the lower the NOI\n\n\nPeople are ok w a lower cap rate because they feel there is less uncertainty in FUTURE NOI\n\nOthers are ok w a higher cap rate because they feel they can mitigate the uncertainty in NOI.\n\nUncertainty = Risk\n\n\nHigher Risk Demands Higher Reward\n\n\nHigher Reward = Investor Wants Higher Yield\n\n\nFinance is an art and a science. Cap rate/ going in cap rate/ terminal cap rate / noi / market research/ due diligence/ discount rates etc etc all need to come together to paint a picture of the investment opportunities.\n\nYou\u2019ll never be exact, but that\u2019s the art. Similar to a painting you need to convince yourself and your critics that its a masterpiece ; )\n\n\nAlso - anyone who makes any investment decision strictly on any cap rate is a moron", "replies": [], "depth": 15}], "depth": 14}], "depth": 13}], "depth": 12}], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "ih40rj6", "text": "If you could buy the same property for a 10 cap or a 17 cap, yes, the 17 cap is less risky. But typically assets that are viewed as higher risk are accompanied by higher cap rates.\n\nIn reality, a 17% cap is probably in a VERY illiquid market (think small town in the middle of nowhere), it\u2019s an asset class where rents are expected to decrease in the future (ie retail), or it\u2019s a very high capex type of real estate (think something like mobile homes, not to be confused with mobile home parks). Remember capex isn\u2019t included in NOI.", "replies": [], "depth": 1}]