Capitalization rates are used by appraisers or buyers/sellers when valuing investment property. They help the buyer to assess the level of financial risk involved with the property. The cap rate is an indication of the level of risk involved with the property.
A very risky property in an area changing from bad to good or just developing will have a high cap rate, indicating a lot of risk involved, as you might lose all or part of your money invested. An established area very easy to rent to tenants would have a low cap rate, indicating not a very risky investment.
Consider the following questions. Put yourself in the place of a buyer for a residential duplex (4 unit apartment property).
- If a capitalization rate is increased in general what effect does this have on the value of the property?
- does the change (increase) in the cap rate cause the value or the property go up or down?
(*to see examples of cap rates please log onto loopnet.com and search properties for sale)