SS264: Understanding Cap Rates (And Why They’re Misleading)

SS264: Understanding Cap Rates (And Why They're Misleading)

Cap rates are a common metric used in multifamily real estate investing, but they can be misleading in certain situations. In this episode, Charles discusses cap rates and how investors can effectively utilize them alongside other valuation methods.

Watch The Episode Here:

Listen To The Podcast Here:

Talking Points:

  • Cap rates are one of the most commonly referenced metrics in real estate—but also one of the most misunderstood. At a basic level, the cap rate represents the unlevered return an investor would receive if they purchased a property with cash. While this makes cap rates useful for quick comparisons between deals, relying on them alone can lead to poor investment decisions. The cap rate provides a snapshot of the property’s profitability relative to its value for a single year. The Cap Rate is calculated by dividing a property’s Net Operating Income (NOI) by its purchase price, and the formula can be manipulated depending on which 2 of the 3 you have.
  • A simple cap rate calculation would be a property with an NOI of $100,000 that is being sold for $1 million. The cap rate would be 10%. 
  • The Net operating income or NOI includes all of the property’s income minus all operating expenses. The NOI excludes mortgage and debt payments and depreciation.
  • A lower cap rate indicates a lower potential return, which usually equates to a higher-quality, more stable, and more sought-after property in a prime market. A higher cap rate usually indicates a higher risk investment in a less prime area. Maybe with deferred maintenance and an unstable tenant base. To learn more in-depth about what a cap rate is and what a reversion cap rate is, check out episode SS76.
  • Why Are Cap Rates Misleading?
  • 1. Ignores financing costs. The cap rate is an unlevered metric; in other words, it does not take debt and financing into account. This doesn’t affect an investor buying a property for cash, but if an investor is financing the property, it disregards all financing terms, which could dramatically change the deal’s favorability.
  • 2. A single-year snapshot. Most investors are purchasing a property to hold for several years, and cap rates do not account for future changes in cash flow.
    • Future rent growth is left out. An investor buying a low-cap-rate property in a high-growth, prime market might have a lower going-in cap rate but higher long-term returns due to large future rent increases.
    • Upcoming repairs and capital expenditures (CapEx) are left out. If the property needs repairs and upgrades, the previous year’s return on which the cap rate is based might not matter, as tenants will leave if these items are not addressed. All of this is left out of the cap rate. 
  • 3. Relies on estimates. The cap rate, like all metrics, is only as good as the numbers used to calculate it. 
    • NOI Manipulation: It is not uncommon for sellers and brokers to underestimate future expenses and CapEx while overinflating future rent increases.
    • Subjective Market Value: Unless the property has just been sold, the value is all an estimate since real estate is an imperfect market, often based on comparable sales where market conditions or deal specifics may differ.
  • 4. Ignores lease quality and risk. The cap rate leaves out the quality of the tenant base. Tenant turnover, tenant creditworthiness, or the length of their leases.
  • 5. Cap rates are market and property-specific. A good cap rate for a new apartment complex in a high-growth market might be 4% while 8% might be a good cap rate for an old retail strip center in a secondary market. 
  • Cap rates are an essential investment metric, but investors also need to supplement the cap rate with additional analysis metrics like cash-on-cash return, gross rent multiplier, internal rate of return, equity multiple, and debt service coverage ratio.

Transcript:

Charles:
What if one of the most trusted numbers in real estate might actually be leading investors in the wrong direction? Cap rates are one of the most common metrics in real estate, but most investors use them without fully understanding what they measure or what they ignore. Welcome to Strategy Saturday. I’m Charles Carillo, and today we’re breaking down understanding cap rates and why they’re misleading. So let’s get started. Cap rates are one of the most commonly referenced metrics in real estate, but also one of the most misunderstood. At a basic level, the cap rate represents the unlevered return an an investor would receive if they purchase a property with all cash. And while this makes cap rates useful for quick comparisons between deals, relying on them alone can lead to poor investment decisions, and the cap rate provides a snapshot of the property’s profitability relative to value for a single year.

Charles:
The cap rate is calculated by dividing a property’s net operating income, the NOI by its purchase price and the formula can be manipulated depending on which two of the three numbers you have. A simple cap rate calculation would be a property with an NOI of a hundred thousand dollars that is being sold for a million dollars, and the cap rate would be 10%. Now, the net operating income includes all the properties, income minus all operating expenses, and the NOI excludes mortgage and debt payments and depreciation. A lower cap rate indicates a lower potential return, which usually equates to a higher quality, more stable, more sought after property. In a prime market, a higher cap rate usually indicates a higher risk investment in a less prime area, maybe with deferred maintenance and an unstable tenant base. Now, to learn more in depth about what a cap rate is and what reversion cap rate is, you can check out episode SS 76.

Charles:
SS 76. So why are cap rates misleading? Number one is that it ignores financing costs and the cap rate isn’t unlevered metric. In other words, it does not take into debt and financing into any account when the calculation is done. Now, this doesn’t affect an investor buying a property for all cash, but if an investor is financing the property, it disregards all financing terms, which could dramatically change the deal’s favorability. Number two is it’s a single year snapshot. Most investors are purchasing a property to hold for several years, and cap rates do not account for future changes in cash flow. This is like future rent growth is left out, and an investor buying a low cap property and a high growth prime market might have a lower going end cap rate, but higher long-term returns due to large future rent increases, upcoming repairs and capital expenditures, CapEx are left out.

Charles:
Now, if the property needs repairs and upgrades, the previous year’s return on which the cap rate is based might not matter because as these repairs are required, and these tenants will leave, if these items are not addressed, and all this is left outta the cap rate. Number three is it relies on estimates. The cap rate, like all metrics is good only as the numbers are. So if you calculate it with bad numbers or inaccurate numbers, the cap rate is gonna be inaccurate. And this happens with like NOI manipulation. It’s not uncommon for sellers and brokers to underestimate future expenses and CapEx while over inflating future rent increases subjective market value. So unless the property has just been sold the value, it’s all an estimate. Since real estate is an imperfect market, often based on comparable sales, where marketing conditions or deals, specifics may differ. Number four is it ignores lease quality and risk.

Charles:
Now the cap rate leaves out the quality of the tenant base, tenant turnover, tenant credit worthiness, or the length of the tenant leases. Number five is cap rates are market and property specific. So a good cap rate for a new apartment complex and a high growth market might be say 4%, while 8% might be a good cap rate for an old retail strip center in a secondary market. Now cap rates are an essential investment metric, but investors also need to supplement the cap rate with additional analysis metrics like cash on cash return, gross rent multiplier, internal rent, greater return equity multiple, and debt service coverage ratio. So I hope you enjoyed, please remember to rate which you subscribe to make comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, please check out our courses and mentoring programs@syndicationsuperstars.com. That is syndication superstars.com.

Charles:
Look forward to two more episodes next week. See you then. Have you always wanted to invest in real estate but didn’t have the time, didn’t know where to find the deals, couldn’t get the funding, and didn’t want tenants calling you? Since 2006, I’ve been buying income producing properties in great locations that provide us with consistent passive income while we wait for appreciation in the future and take advantage of tax laws while we’re waiting. And unlike your financial advisor, we invest alongside our investors in every property we purchase. Check out invest with harborside.com. If you like the idea of investing in real estate, if you like the idea of passive income, partner with us@investwithharborside.com. That’s invest with harborside.com.

Links Mentioned In The Episode:

  • SS76: What is a Cap Rate and What is a Reversion Cap Rate?

Are You a Fan? Subscribe, Rate, Review & Share – Click Here To Learn How

What question do you always wish I would ask but I never do?

Connect with the Global Investors Show, Charles Carillo and Harborside Partners:

Scroll to top