Real estate investors frequently ask, "What's a good caprate?" This is often a question they are asking. Or, "If I take the cash flow from an asset, without taking into account mortgage payments, and divide it by the purchase price to reach the capitalization rate (caprate), what return would be desirable for a commercial property asset bought with all cash?" Simply put, there is no universal cap. It is dependent on many factors. Also, how one defines "good" (For the purposes of this discussion, the term "good" will be used to describe any favorable investment one might make). For those who get frustrated by the "it depends” response, the broker package is a good place to start looking for guidance about possible cap rates for purchasing an asset. Here you will find comparable sales cap rates. Be skeptical as these assets could be cherry-picked or not truly comparable.
Many advisors will tell clients that a high caprate is better. They also recommend that the cap rate be between 5% to 10%. It is true that an investor should always invest in property with a higher rate of cap. A higher cap rate will predict a higher yield. But cap rates do not mean everything. The decision to buy property should take into account investor risk appetite, location, property condition, growth potential, NOI and many other factors. Investment opportunities with low cap rates may be attractive to certain risk-averse investors.
Here's a summary of how investors can determine what a "good" cap rate in any particular market or asset.
Debt is not included in cap rates. Other return metrics such as cash on cash returns and internal rate (IRR), should be calculated. They provide a wider view of the opportunity.
Additionally, cap rates can change over time. They can change depending on changes in building value or NOI. Market conditions and improvements made by investors to the property may also affect this change in return value.
Cap rates can be used as a proxy to help determine whether an investment is safer or more risky. A lower caprate is associated with a safer investment or one that is less risky, while a high cap rate is associated with greater risk.
Investors should choose the property with the highest cap rate. This is because it predicts a higher return.