Cap rate is a complicated concept, but basically it means your Return on Investment, or ROI, for a particular property.
You can have two identical buildings which sell for a slightly different price, and they’re going to have a different cap rate, because price of sale determines cap rate.
The formula for cap rate is net operating income divided by sales price. Now, by decreasing the cap rate of a building, you’re increasing its value.
As an example, if you have a building that is a 10 cap and you decrease it to a 6 cap, you’ve doubled its value because people are paying more per dollar for the income of the property when they buy at a higher cap rate.
In some areas, like capital preservation areas with super high demand, cap rates can even go negative, where you’re paying a premium, losing money just to buy the property. Because it’s preservation, like some top areas of Birmingham or some areas of New York City, buyers determine it’s worth the investment.
In Detroit real estate investment, we deal with double-digit cap rates at times. The goal is to reduce those by stabilizing buildings and handling smaller intangibles.
People buy because of numbers, but they also buy because of emotion. If you have a building that looks better than an identical building next door, the one that looks better is going to sell for more and earn a lower cap rate.
If you can take your ugly building and make it pretty, those changes can affect the value of the property.
For owners and landlords, handling deferred maintenance can decrease the cap rate. By maintaining and improving a property, you increase its value.
That increases your operating income, as you improve the way a property looks and functions. Think about it: your rents creep up, expenses don’t increase at the same rate, and you generate an accelerated revenue stream which gives you better cash flow and value for your investment.
It’s a lot of math and explanation to say, do things right and you’ll reap the rewards.