Asset capitalization rates, commonly known as cap rates, play a critical role in commercial real estate analysis. There are inherent shortcomings in this metric that should be considered. In this article, we discuss the positive and negative qualities of cap rates and how they are manipulated.
What is a Cap Rate
A Cap Rate is a metric used to assess potential investments and objectively compare one with another. Cap rates are often viewed as indicators of risk and reward, informing investors of the potential investment’s opportunity for success.
Cap rates can vary significantly depending on the type of property. Multifamily properties are residential units in a single building or community, assessed based on market rents as residential assets.
How to Calculate Rate Cap
A lower cap rate suggests lower risk and higher value, and a higher cap rate indicates higher risk (such as age or inferior location) and lower value.
However, as you delve deeper into the financial modeling of multifamily properties, you realize that cap rates are influenced by various assumptions that impact their reliability as risk and reward indicators.
What is NOI
The calculation of NOI, a key component of the cap rate formula, can be complex and subject to variability. For instance, when projecting factors such as taxes, property management, maintenance, vacancy, and bad debt, there are opportunities to overlook or rely on unreliable estimates. For example, uncertainties such as the COVID-19 pandemic. As you gain experience and develop your risk assessment approach, it’s crucial to critically evaluate the integrity of cap rates and carefully consider the reliability of the assumptions used in a sponsor’s calculation.
How to Calculate NOI
Cap rates, a [flawed] key metric:
One common misconception about cap rates is that they are solely a measure of risk. However, our company conducted research by surveying trusted contacts, including high-net-worth individuals, family offices, and other equity and debt sources who rely on cap rates as a key metric in their daily operations. The analysis revealed that cap rates depend on market nuances and property specifics, not just risk assessment.
We asked: Which is preferable, a 4% cap rate or a 7% cap rate?
The prevailing sentiment was that a higher cap rate was seen as better. However, the reality is that there are situations where a lower cap rate could potentially offer a more lucrative opportunity. This is especially true when considering some less obvious examples that, once addressed, could result in a higher cap rate for the asset. Two such examples are:
- Below market rents: If the property in question is currently charging rents below the prevailing market rates, there is a possibility to increase the rents to match the market, potentially resulting in a higher cap rate.
- Value-add component: The property has untapped potential for value-add opportunities, such as renovations or improvements that could increase its overall value.
- 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, garbage pick-up, 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, investors
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.
The Integrity of the Cap Rate
While cap rates can provide valuable insights into your potential return on investment, they also have their limitations. To truly assess the value of a property, it’s important to focus on the property itself, excluding mortgage expenses, and consider various factors when evaluating the cap rate.
Factors to Consider When Evaluating Cap Rates:
- Location: The neighborhood where the property is located can significantly impact its market value and rental rates. Generally, properties in desirable neighborhoods tend to have higher market values and rental incomes.
- Asset Class: The type of property, whether it’s core, core plus, value-add, or opportunistic. These help determine the amount of upside and risk associated with the property.
- Available Inventory: Supply and demand dynamics in the market for the specific asset class of the property can influence the cap rate. Understanding the availability of similar properties in the market can provide insights into the property’s competitive position.
- Regional Fundamentals: Factors such as population growth, employment growth, and availability of comparable properties in the region can impact the economic performance and cap rate.
Lower Exit Cap Rate (header 3)
When selling a property, if the expected cap rate decreases but rents remain constant or increase, the selling price will be higher than the purchase price. In other words, a lower “exit cap rate” is a positive for investors.
Remember that a cap rate also measures risk. A lower cap rate implies the market, therefore the asset is relatively a safe investment. A lower cap rate is typical of a “core” or “core plus” property. This investment is generally less risky but has lower upside potential.
The inverse is also true, a higher rate cap does not guarantee the highest potential return. Cap rates alone do not determine whether a property is a good deal.
Drivers of Cap Rate Compression (header 2)
- Decreases in interest rates- reducing the cost of capital and driving up property values.
- Economic Improvements in the market- such as population growth from net in-migration, job opportunities, and cost of living.
- Improvements to the property, such as renovations of the amenities and apartments to improve the assets’ position in the marketplace.
How Cap Rates Impact Multifamily Investments
As with any investment, mitigating risk requires thorough due diligence and adherence to best practices. It’s crucial to work with honest and transparent sponsors. They should provide insights into their investment philosophy and risk mitigation strategies. Assessing the sponsors’ experience, background, and risk tolerance in relation to your own is essential. When working with brokers, consider their motivations and whether they align with your interests. Investing time in acquiring knowledge, cross-referencing and verifying information, and continuously learning will be key to your success as an investor.
To learn more about evaluating deals and choosing your next sponsor read our blog: Multifamily Investment Blueprint
