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What Exactly is a Cap Rate?

Do you know what a cap rate is?  When I first started flipping properties I had no clue what it was.  When I first started I was concerned with one thing only which was cash flow (and you should be too).  However, when you expand your horizon and look at larger projects with varying monthly cash flows you need to consider different metrics.  One such metric is the capitalization rate (cap rate).  

In its simplest form, the cap rate of an investment is derived by taking the investment’s net operating income (NOI) and dividing it by it’s present value (or purchase price), where NOI is derived by taking the performing asset’s income and subtracting it’s operating expenses (be careful not to include any type of debt service here).

     In a formula, it’s given as cap rate = NOI/Present Value

     Which also means, NOI = Price * cap rate & Present Value of Asset = NOI/cap rate

How about an example?

     You want to buy a 100-unit multifamily apartment complex.

     The financials state that the NOI on the performing asset is $75,000.

     You can purchase the property for $1.2MM

     Cap Rate = $75,000/$1,200,000 = 6.25%

What is a Cap Rate to me?  

From a seller standpoint, it helps me determine what a buyer may be willing to pay for my performing asset.  If my property has an annual NOI of $10,000 and I believe my buyer will want a 7% return (based on my knowledge of similar and alternative assets available to most buyers in that market) I could assume that a buyer would be willing to pay $142,857 for my asset.   I must remember that my cap rate needs to be competitive in the market and that there are other opportunities competing for my buyer’s dollars.  Should a buyer buy my asset if it provides a 4% return when he can get an almost risk-free bond at 3.5%?  In some situations, the buyer may choose either or depending on his or her risk tolerance and tax needs.

From a buyer standpoint, it helps me by looking at comparable sale cap rates.  It shows me the return I can expect if I pay for the entire property in cash but again, helps me compare apples to apples when looking at other performing assets in the market.

Let’s get back to that example of the 100-unit multifamily apartment complex you want to buy.  Let’s assume you don’t know the price of the asset, as it’s advertised as “market price” or “market bid” which doesn’t help you in determining an offer price.  Market price challenges you figure out what the market is willing to shell out for that asset.  After some further research, you determine this property is in a very desirable neighborhood and your due diligence also reveals that there was very little deferred maintenance or capital expenditures needed to be performed by a new buyer.   This new property may be considered a Class A property.  Let’s assume it is.  We can now start to look at other Class A sales that have taken place recently near our subject property.  The caveat here is not many sellers/buyers/real estate agents are willing to divulge the market research you want without a handout so it’s best to work with a real estate broker who knows the area and the players well.  Once you determine the comparables were selling around a cap rate of 3%-4% we now have a point where we can assume other bidders will start bidding.  Based on the only knowledge we have in this example, the NOI being $75,000, we can arrive at a market price range of $1.87MM & $2.5MM.  At this point, it’s up to you, your negotiation skills and that of your bidding competition.  

If you are willing to take a bit more risk, you may be willing to head down the street to a less desirable part of town where you may be able to purchase a property for around an 8% cap rate.  The difference in cap rate, over the 4% cap rate of the safer investment, is your risk premium.  This may be a Class B property that has lower economic fundamentals, shorter tenant leases, older property and many other factors which make owning this property slightly more frustrating for you.  Since this is doubling your cap rate though, are you willing to deal with these stresses and additional risk on your investment?  There is no right answer, it’s all up to the individual investor’s risk tolerance.

First Rule of Cap Rate Club

The example I gave you above is almost elementary and never happens.  Round numbers, available quality comparables, complete faith in your due diligence and financials from a seller we can trust (we will save this topic for another conversation).  

The first rule I tell all my clients.  We never trust a seller’s proforma.

The second rule I tell my clients.  We never trust a seller’s proforma.

Do NOT Trust the “Amazing Value-Add Opportunity” and it’s “Wondrous Proforma cap rate”!

The whole concept of proformas and discount cash flow analysis baffles me.  I mean, I understand the process and formulas, but to assume that a set of cash flows will grow X%, in perpetuity (or even 5 years) is just silly in today’s ever-changing market.  But, it’s acceptable, as we have been doing it for so many years now, buyers believe it’s what we must work with.  NO.  This is what most lazy brokers do.  Don’t accept that.  Do your own ‘conservative’ discount cash flow based on actual financial data from the seller—that’s the way to assure you aren’t being starry eyed about a seller’s “amazing value-add opportunity”.  If you can’t obtain actual financial data from a seller but still feel the need to absolutely buy that asset, make an offer based on an absolute worst case proforma scenarios that your attorney, CPA and real estate broker can come up with—at which point you will probably not buy it.  Pardon the cynicism here, it’s okay to trust but as you know, you must verify.

 

Complications, Issues & Limitations of the Cap Rate

  • Cap rates assume you are using quality comparables which are not always easy to obtain.  To be considered a comparable the other property should be in a similar location while having similar functionality, age, construction, size and be in the same general quality.
  • The cap rate will not tell you what your leveraged return will be when you buy the property with debt.  Even if we could afford to purchase with all cash, many of us would choose to borrow and earn a higher, leveraged, cash-on-cash return (careful here, leverage magnifies risk).
  • The cap rate is limited.  It only tells us what our annual return should be the first year (after purchasing the asset in cash).  Where is the neighborhood going? How are capital expenditures going to be handled over the next few years?  What about expenses, leases and rents over the life of the property?  The cap rate is NOT a crystal ball for the life of a performing asset.
  • Cap rates fluctuate over the course of market cycles.  Right now, in the multifamily market, they are compressed in most MSAs, as buyers are bidding up the prices of available inventory.  Like all cycles, it will reverse and cap rates will expand in the multifamily market.
  • The cap rate should not be used if the income or expenses of the performing assets are erratic.  Commercial real estate works well for cap rates because their income and operating expenses are somewhat predictable.
  • No two operators will run the asset the same way so cap rates will not always predict your exact cash flow, even in the first year after acquisition.
  • Cap rates can be manipulated rather easily based on a seller’s proforma.  The best practice is to find your own cap rate by doing your own proforma on as many actual financials from the seller as possible.

 

Final Thought: Cap Rates = Risk vs Reward on Various Investment Opportunities

I like the cap rate metric because it allows me to compare two investment opportunities and choose the better one for me and my risk tolerance.  I know what the risk-free rate is.  I have options to put my money in a US Treasury bond, a CD or Class C office space—I also know the ease or headaches associated with each.  To me, the cap rate is a measure of risk & reward.  I know I will collect periodic cash payments that are predictable in either case but there is a risk that they won’t come (or come with a headache) when I’m willing to take a higher risk premium.   However, there are risks we must consider if our required rate of return, needed to meet our goals, is higher than the (low) risk-free rate.  If I am requiring my assets to generate 8%, to meet my goals, I must be willing to accept some risk (that’s the risk premium I mentioned before) which is currently more risk than staying with a risk-free rate investment.

I hope you enjoyed my take on what the cap rate means to me.  I plan on doing another paper on common real estate investor definitions [soon].  If you made it to the end of this long article I thank and congratulate you!

Here for you in success.

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