The cap rate is unquestionably one of the most extensively utilized real estate investment measures, but to me, people over-index on cap rates and that is a recipe for disaster.
It is a great measure but should not be the only measure for the deal.
So today, I want to double click on:
- How significant is a cap rate?
- Should you utilize a cap rate to drive your real estate investing decisions?
- Should you use different investing criteria completely to value a real estate transaction?
If you've been in real estate for any length of time, you're probably aware that the cap rate is just the deal's net operating income divided by the buying price.
So, if you're considering a deal with a purchase price of $1 million and anticipate earning $60,000 net operating income in the first year, your cap rate for that deal would amount to 6%.
Therefore, you would earn a 6% cash return on your investment, assuming there is no debt on the property.
This metric may appear helpful at first glance, and it is frequently useful just to establish a baseline of where the worth of a property may be.
However, I think the cap rate ignores a heap of other critical aspects in a real estate investment that will ultimately determine your earnings during a five, seven, or ten-year holding period.
We'll go through the five primary drawbacks of just utilizing a cap rate to assess a real estate purchase and what you should do instead.
Let’s dive in:
The first is that cap rates do not account for debt. Given that most real estate investments are leveraged, which means they have debt on the property based on that 6% cap rate.
Real estate is often a negative leverage investment. By adding debt to the property, your cash return or 6% cash yield would be lower than without it; especially in a high-interest rate environment.
What most people don't realize is that anything greater than roughly a 4.25 percent interest rate on a 6 percent cap rate agreement would put you in a negative leverage scenario, which means your cash on cash or cash flow return on your initial investment will be lower than 6%.
The second issue is that cap rates do not account for capital expenditures. Especially if you're dealing with an older property, you may expect a lot of tenant renovations.
Capital expenditures are what I call below-the-line items in technical terms. The margin of error is higher in the estimations, so most people leave them out of net operating income calculations, introducing the error margin in the cap rates.
Thirdly, many properties in coastal markets and big metropolitan centers now have significantly lower cap rates than homes in the Midwest or more suburban or rural locations that are less densely populated. When an investor assumes that a 7.5 percent cap rate in Cleveland is inevitably better than a 4.5 percent cap rate in New York City, they are overlooking the fact that market rent growth and potential in New York City is substantially higher than in a Midwest market like Cleveland.
While you see a property with a 7.5% cap rate from day one, five years from now, the net operating income in that market could be the same, whereas the property you acquired in a large urban center like New York City is likely to have a substantially greater net operating income.
Fourth, cap rates do not take into account renovation premiums or leases that are marked to market. When you initially look at a bargain, you might believe that buying one with a 3% cap rate is just ridiculous.
What if I told you that the building was only 45 percent occupied, that the in-place rents were a full 20% below market rates, that the property is in a terrific market, and that the 3 percent cap rate could increase to a 7 percent cap rate in less than a year? Would you believe the deal is insane now that you know it? So, even if you're looking at a 3% cap rate, that figure says nothing about the deal's total profitability and prospects.
Finally, cap rates do not take into account the value of a sale.
Assume you acquire two deals for $10 million a piece and put up $5 million in equity on each. As a result, you obtain a 50% loan on each deal.
The first property you buy isn't one with a negative net migration rate. So people are moving out and they are moving in while there is no employment development in the area. And you'll get a 6.5% cap rate on the property. In today's market, it seems very nice.
Let's imagine you acquire another $10 million property with $5 million in equity, but this time in an emerging strong market with plenty of job development potential, and you pay a 3.5% cap rate. On the surface, a 6.5% cap rate appears to be preferable to a 3.5% cap rate.
Let's fast forward two years to when we sell both properties. Because the first property was purchased in a market that wasn't experiencing much development, you saw very little improvement in your net operating income, and as a result, your value ended up selling that deal for around $10.5 million.
After commissions and other sales, charges have been deducted. Even with your cash flow over the previous two years, you barely broke even on the transaction. However, your valuation on the second deal has now skyrocketed. So, in just two years, your rentals have increased dramatically and your net operating income has increased even more; and you're able to sell the property for $15 million.
Even if you pay off your $5 million debt in two years, presuming you haven't paid anything down at that time.
Even though you acquired the home at a 3.5% cap rate, you more than quadrupled your initial investment while the 6.5% cap rate appeared to be slightly better on the surface than the 3.5% cap rate, at the end of the day.
When the selling value is taken into consideration, the 3.5% cap per deal wins every time. At this point, I hope I've convinced you that, while the cap rate might be useful, it shouldn't be the be-all and end-all for determining what your property's value should be.
So, what is the return measure you should be utilizing to appraise a real estate transaction?
I look at the internal rate of return, or IRR, as a return metric in all my transactions.
Why is the IRR the best metric to utilize when investing in real estate?
Basically, the IRR takes the five components we just discussed, ties them all together, and offers you an annualized rate of return on your investment.
This is beneficial for investors who are considering real estate as a primary investment vehicle as well as comparing it to other investment vehicles such as stocks, bonds, and private equity.
The IRR will simply provide you with a more accurate picture of the deal's total returns, taking into consideration all of these distinct elements as well as the overall cash flows you'll get.
I hope this gives you a different way to look at cap rates. It is an important measure but should not be the sole indicator.