When investing, it’s important to think in terms of Risk vs. Reward. The type of investment you’re making, whether it’s real estate, stocks, art, or other investments, is less important than evaluating whether the potential return from any of the options available to you is worth the risk you’ll take by investing. The temptation is to invest in things you’re comfortable with; you may be familiar with real estate and so you might focus your investment solely in that area, but you should only do so when the risk and reward are properly balanced.

For real estate, abide by this guiding principle: The riskier the property is to invest in, the higher the potential reward must be. If you purchase a newly constructed property which is already performing well, the risk is low. Your upfront cost of purchase will be higher, and the return will be commensurately lower. Conversely if you are looking at a property that is older and need of some repair work, and potentially has some problem tenants that need to be evicted, your risk is much higher. To be worth considering the potential return needs to be that much greater, and the upfront cost of purchase needs to be much lower.

A more extreme example is construction of new commercial property, the riskiest real estate investment you can undertake. Factors which compound the risk are numerous, including lengthy construction times, financing risks, and the effects of market fluctuations. Due to the high level of risk involved, your upfront costs should be as low as possible.

To provide numbers as a point of reference, consider three hypothetical investment opportunities on Long Island:

• A fully performing Class-A apartment building. If this is the building you’re going to purchase, you want to do so between a 4 and 5 cap
• If you’re looking at purchasing a “value-add” type of property, you’ll do so at approximately an 8 to 8.5 cap.
• Finally, for ground-up construction, the riskiest investment, you’ll want to between a 12 and 15 cap.

To reiterate, consider any potential sell my house fast investment, in real estate or otherwise, in terms of Risk vs. Reward. Know your capacity for risk before entering into any investment, and perform a thorough analysis to be sure that the potential rewards will be worthwhile.

In the simplest terms a cap rate is the way that commercial real estate is valued, measuring the risk vs. return for a given property. You can compare a property with a low cap rate to a savings account – in a savings account there is essentially no risk of losing the money you’ve deposited but the return in the form of interest is very low. In contrast, a high cap rate property is more like investing in stocks – the potential returns are much greater but there is a real risk of losing the initial investment.

In general, high cap rate properties generate more cash flow and are less expensive to purchase, whereas low cap rate real estate generates less cash flow and is more expensive to purchase.

Cap rates also act as a multiplier which help determine property value. Imagine a property with a Net Operating Income (NOI) of $100,000. The NOI is defined as the gross income minus the vacancy rate and all expenses associated with maintenance and operation, excluding mortgages (if any). By dividing the property’s NOI by the cap rate of the market, the result is the value of the property.

For example:

• $100,000 NOI in a 10-cap market, or 10% return: $100,000 is divided by 10% (.10), resulting in a property value of $1,000,000.
• The same property, with the same $100,000 NOI in a 5-cap market: $100,000 is divided by 5% (.05), resulting in a property value of $2,000,000.

The same property, generating the same NOI, is valued differently based on the market and the associated cap rate. Since the cap rate acts as a multiplier on the NOI, every dollar the NOI for a property increases (for example by increasing rents or decreasing expenses) is multiplied by the cap rate percentage. With a 10-cap market, every extra dollar of NOI is divided by 10%, therefore adding an extra $10 of property value. In a 5-cap market, each extra dollar of NOI is divided by 20%, adding $20 of property value. Leveraging this multiplier effect at the right time is an important way that real estate investors can generate returns on their investments.

As a final note, familiarity with cap rates and how to use them to make money is a concept which carries over into other forms of investing outside of real estate and sell my house fast Long Island deals, and is very much worth taking the time to learn.