Factors affecting Cap Rates. There are many factors affecting cap rates. Firstly, there are macro level economic and demographic issues, such as land availability in regulatory environment where the building exists. Secondly, the type of property. Each sector of REITs carries their own risk, whether it's retail, residential, office building, lab offices, warehouses, each have their own cyclicalities and sensitivities. Lastly, are the micro-level market influences, such as property class or lease type. Now, property classes are ranked by letter with A being the most desirable. These are the highest quality buildings in their market and area. They are generally newer properties built within the last 15 years, have top amenities, high income earning tenants and low vacancy rates. Class A buildings are generally well located in the market and are typically professionally managed. Additionally, they typically demand the highest rent and there's littler no deferred maintenance issues on the building. Class B are a step down and they may require some maintenance. They're seen as value added and may not be professionally managed. Class C are older buildings. They need maintenance, they have less desirable leases and they're in less desirable markets. Obviously, Class A buildings are generally the lower cap rate buildings, with Class C buildings being higher cap rate. Leases are classified as net, double net and triple net. Double net is sometimes referred to as a modified gross lease. And net is sometimes referred to as a full service lease. In triple net leases, tax, maintenance and insurance are passed on to the tenant as an additional charge over the rent. The landlord usually handles structural issues like roofs. A modified gross lease typically binds the landlord to pay for the real estate property taxes, the insurance and common area maintenance, while the tenant takes responsibility for its own utilities, interior maintenance and janitorial services. The landlord usually is responsible for roof and structural elements, just as in a triple net lease. Because the landlord is taking on more expenses in a triple net lease, the rental rate is usually a little bit higher. In a full service lease, just as the name implies, the lease covers all, or almost all of the operating expenses. Some of the few exceptions are telephone and data expenses. Otherwise, the landlord pays the taxes, the insurance, the common area maintenance, the interior maintenance, janitorial, utilities, and so on. As a result, the rent is relatively high. These types of leases usually occur in a multi-tenant office building where it's too difficult or cumbersome to divide up the utilities among the tenants. Full service leases would be the least desirable from the landlord's perspective and can often reflect a higher cap rate.

Let's look at applying the cap rate to a couple of investing decisions. Property One is a tried and true investment with little risk. It has a cap rate of 6.48%, which is effectively the net operating income of 64,800 divided by the listing price of 1 million, and the multiple, which is the inverse of the cap rate, is 15.4 times. Property Two is an up and comer and that requires some investment. It will also likely require some time to stabilize its earnings. Because of this, it's cap rate is harder to calculate but we know that it is definitely higher than Property One. In this case, the asset value is calculated by taking its listing price and adding any investment that is required. The new asset price is 950,000. It's operating income of 84,000 gives you a cap rate of 8.84%, which is, in fact, higher than the cap rate of Property One. The multiple, the inverse of the cap rate of Property Two is 11.3 times. Clearly, Property One is a higher value building. That does not necessarily make Property Two a bad investment. It is just important to understand what is driving the value.