Can the Long Term & Quality of a Rental Tenant Affect the Cap Rate?
The cap rate is one of the three main ways to value real estate. Many factors can affect the cap rate including interest rates, inflation and the property valuation. A cap rate can also be affected by the quality of a tenant and how long a tenant stays at the property.
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Cap Rate
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The cap rate is a measure of a real estate property's income generation qualities versus how much it costs. It is calculated by dividing the net operating income of the property by the price. Note, the net operating income is the net of interest expense so the cap rate can vary from investor to investor depending on how much debt is part of the capital structure and the credit worthiness of the borrower. For example, a company is looking at a real estate property. It figures the property will cost it $100,000. It estimates the net operating income will be $10,000. The cap rate is simply $10,000 divided by $100,000 or 0.1.
Length of Rental Tenant
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The length of a rental tenant per say does not affect the cap rate. However, once you figure out that it takes time to find a new tenant and there will be a few months when the property will be empty, the length of a rental tenant does affect the cap rate. If possible, a person leasing out the property would want to have the same tenant in the property for the whole time he owns it. If that occurs, there are no vacant months. There also is no expense for a real estate agent and commissions paid for finding new rental clients. No vacancy expense plus no real estate commissions increases the net operating income without increasing the value of the property, therefore increasing the cap rate.
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Quality of a Rental Tenant
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The quality of a tenant affects the cap rate directly. A real estate property owner wants a tenant who will pay on time and will take good care of the property. If that does not occur, the owner will incur property expenses and expenses for late payments. Those payments lower the net operating income but do not lower the market value. A smaller numerator and the same denominator leads to a smaller fraction, so the cap rate falls.
Real Estate Valuations
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The other two real estate valuations commonly used are the sales comparable approach and the cost of replicating approach. The sales comparable approach is when an investor looks at similar properties sold and makes adjustments to better match the relevant property to come up with a sales price. The cost of replicating approach is when an investor estimates how much it would cost to build a property that will closely match the relevant property as closely as possible.
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References
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