**Definition.** The cap rate is the price of the home divided by its net operating income (NOI). Typical values for homes in low-risk areas of San Francisco are 4.5-5.5%. **"Unlevered"?** One way to think of it is how long it would take for a property to pay for itself if you bought it in cash. For example, a property with a 5% cap rate would pay for itself in 20 years. Hence, "unlevered yield on cash". **Relationship to risk.** A higher cap rate (like 7-8%) implies that the property is more risky, and that you'd need more income for your acquisition to be worthwhile. A lower cap rate (4-4.5%) implies the property is lower risk, meaning that you can expect a more stable income stream from the property. Properties with a stable and predictable NOI are perceived as less risky. Factors that contribute to stable NOI include: - long-term leases with creditworthy tenants - well-maintained properties (that are less likely to have expensive maintenance issues) - strong market conditions Factor that contribute to unpredictable NOI: - short-term leases - economic downturns - poor property management It's common to hear an investment pitch modeling an "entry cap" (the cap rate at property acquisition) that is *higher* than the "exit cap". This is because a good developer will look for opportunities to: - Buy in an area that's becoming **increasingly desirable**. High desirability is good for the stability of NOI. - **Improved NOI**. Higher NOI is generally associated with wealthier tenants, which are generally more reliable in their payments and less likely to cause problems (like defaulting or, God forbid, squatting). **Modeling multiple exit caps**. Because you can't know your exit cap at acquisition, it's nice to model multiple scenarios. Instead of guessing at a range of exit prices directly, an investor will model a plausible range of exit cap rates given NOI projections, and then use those two numbers to predict a range of exit prices. Here's an example from a [real offering memorandum](https://drive.google.com/file/d/1MPDg7NrrvPnePch5f8OiJ5yM_gkvjUYI/view): ![[Pasted image 20240603174546.png]] These cap rate projections are translated behind the scenes into a sale price, which are then translated into an [[Internal rate of return (IRR)]] and corresponding "equity multiple", both of which are measures of the investor's return. The [same memo](https://drive.google.com/file/d/1MPDg7NrrvPnePch5f8OiJ5yM_gkvjUYI/view) discusses how cap rates change throughout the life of the deal, with language like: "The going-in cap rate is 6.6%. The stabilized cap rate is 7.0% to 8.0%. The exit cap rate is modeled at 5.4%."