The following gives an overview of how an investor might decide what a good' caprate should look like in any market or asset.
All things being equal, an investor should only invest in the property that has a higher rate of return.
Additionally, debt is not considered in cap rates. Other return metrics should be considered, such as cash/cash returns and the internal rate of Return (IRR), as they give a wider picture about the potential.
Many advisors would tell you that a higher rate of return is better. Part of this is true. An investor should invest in property with higher cap rates because they predict higher yields. Cap rates are not everything. Investor risk appetite, property location and property condition, potential growth of NOI, as well as many other investment-specific considerations should all be considered when deciding to purchase a property. If you are a risk-averse investor, low cap rates could be worth considering.
Cap rates are also not fixed. They fluctuate according to the changes in the building's value and NOI. Market conditions, investor improvements and property upgrades can also impact the return value.
Real estate investors are often asked the question "What is an acceptable cap rate?". There is no universal cap-rate that can be targeted. This depends on many factors. If you're frustrated by an "it depends!" response, the broker package that lists comparable sales rates is the best place to find guidance on possible cap rate for buying an asset. Take care to not make assumptions about the asset's actual comparability, as they may have been cherry-picked.
Risk Profile: All investments, whether real estate or other, have returns that directly correlate to risk. A treasury Bond, which is guaranteed with the full faith, credit, and goodness of the US Government, has a relatively low rate of return. As junk bonds are considered more risky and have higher returns and have higher probability of default, they can be redeemed at a higher rate. A lower cap rate (less then 5%) often means that you have a lower risk profile. An investment with a higher cap (greater 7%) is more likely to be considered riskier. The investor's perception of a cap-rate as "good" will determine whether the investment's return is worth the risk. A Class A 98% occupancy multifamily asset in San Francisco, offered at a 3.3% cap rate by an investor, may be chosen by the investor. A Class C single tenant office, located in Richmond Virginia, is being offered at a 100% occupancy with 8% as a "good cap rate". Both the investor and the seller are right to see that there is a variance in risk preferences and a desire for lower risk, higher return, or lower risk. A real estate investor should ask the question, "Does it reflect the risk I am willing take, all things being equal?"
