The capitalization rate, or cap rate, represents the rate of return on an income-producing property when applied against the purchase price. One could say, therefore, a high cap rate is a “good” thing. If so, then why does a high cap rate mean a higher risk investment?
The cap rate is calculated by dividing the net operating income by the purchase price. In calculating the net, certain expenses personal to the particular owner or prospective buyer, such as debt service, are not included.
For example, if the NOI is $250,000 and the purchase price is $3,000,000, dividing $250,000 into $3,000,000 yields a cap rate of 8.3%.
Compare that to a property with an NOI of $300,000 that also sells for $3,000,000. The cap rate there is 10%.
Why would someone pay the same price for a lower NOI? This is where the market comes into play. The answer often lies with the quality of the tenant. Investors will pay more, so to speak, to get what they perceive to be more reliable income.
The time remaining on the lease can influence this analysis as well. Even with a great tenant with a solid NOI, an investor may pay less if only one year remains on the lease versus a lease with seven years remaining, thus driving up the cap rate.
Therefore, in some ways, buyers of commercial real estate invest in the tenant.