Managing Partner, Capital Markets at PIA Residential.
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Cap rates are more formally known as asset capitalization rates and are important for commercial real estate analysis. I’d like to shed a light on cap rates — and the way they are used and manipulated. Cap rates contain both positive and negative qualities, and while they can be invaluable in assessing risk, there are apparent shortcomings inherently built into this metric. The real take away here is the process in which you mitigate risk.
A Common Misconception
My company researched the overall thought processes of how cap rates are perceived by surveying several trusted contacts. This group consists of high net worth individuals, family offices and other equity and debt sources that rely on cap rates daily as an essential metric.
The inquiry was simple: What is better, a 4% cap rate or a 7% cap rate?
The responses varied, but the prevailing theme was that a higher cap rate was better. The truth of the matter is that there are instances when a lower cap rate could prevail and provide a better opportunity. Below are a few not-so-visible examples that would lead to a higher cap rate on the asset once remedied.
• Below market rents.
• Needs a value-add component.
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• Located in an area that is gentrifying.
• Better debt terms — although the cap rate might be lower, the cash-on-cash may be higher.
• Has a significant expense that can be reduced or mitigated, i.e., separate water metering.
• The property is not collecting ancillary fees: parking, late fees, etc.
As you dive into the intricacies of cap rates, remember a few basic investing principles. As risk increases, there is a need for a greater return. Since returns are directly proportional to the amount of risk, I view this through a lens where when deriving risk, you conclude that risk plus risk (R+R) is not two times risk (2R), rather risk squared (R²).
The bottom line is that you must learn how to identify your risk and calculate your returns. Determining the cap rate is a necessity and may be extremely useful. This fundamental task has its value, but blindly relying on cap rates could create a mirage of optimism that is not accurate.
What Is The Capitalization Rate?
In commercial real estate, an asset’s capitalization rate or more simply, a cap rate, is a viewpoint of an asset’s return in a specific period. The formula is quite elementary; you take the asset’s net operating income (NOI) and divide it by its value. In theory, the usefulness of a cap rate is very straightforward. A low cap rate indicates lower risk and increased value, and the higher the inverse, the more risk and lower value. As you continue to understand the financial modeling used in underwriting assets, you notice that many assumptions have gone into these seemingly reliable risk and reward indicators. It would be best if you also accounted for NOI’s reliability and the variables affecting the cap rate.
The calculation you use to establish NOI is an integral part of the formula for setting the cap rate and is fraught with variability. Will you be focused on standard prognostications such as taxes, property management, and maintenance or variables such as vacancy and bad debt? The latter is increasingly more critical in a market affected by the coronavirus; however, there are at least a dozen opportunities to overlook and depend on unreliable estimates, adversely affecting your investment outcome. As you build your experience and thought process in evaluating risk, really consider the integrity of cap rates.
The Integrity Of Cap Rates
The integrity of a cap rate is built upon the forward-thinking data set used in deriving NOI. Cap rates as an indicator of your return have clear advantages and shortcomings. What creates the most significant value is the ability to focus on the property itself. With the exclusion of mortgage expenses, the cap rate formula allows you to compare one property/market to another. When evaluating the cap rate, you must analyze these factors:
Location: Typically, a great neighborhood has a higher market value, equaling higher rents.
Asset Class: Property type, such as single-family, multifamily, or other commercial properties.
Available Inventory: Supply and demand metrics in the market for the asset class of the property.
Regional Fundamentals: Population growth, employment growth, and inventory of comparables.
Whether you are calculating the market, enter or exit cap rates, you need to understand potential issues and misinformation to mitigate risk. A few clear reminders include higher cap rates do not always mean higher returns and do not make a good deal alone. Additionally, rising interest rates do not automatically raise cap rates, and when using a proforma, the rents and expenses are merely projections — in many cases, the best-case scenario.
Cap Rates Are Complicated
As with any new endeavor, you can take steps to mitigate risk by proper due-diligence and best practices. Seek honest and transparent sponsors and operators. When you realize that much of the underwriting you rely on to assess risk and future performance is forecasted, you must strive to understand the derivatives of their return conclusions.
Most importantly, study and research the sponsors. Discuss with them their investment philosophy and how they plan to mitigate risk. It is crucial to ask yourself, “Does their risk tolerance align with mine?” and “Do they have the experience and background to protect my investment?” When relying on brokers, make sure to think about their motivations and whether they align with your interests. Also, do not forget that the data is already out there; self-education is a practice that should never be underutilized or forgotten. While it is vital to research, cross-reference, and verify the information you read, investing your time into acquiring further knowledge will be essential to your success.
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