Asset capitalization rates, commonly known as cap rates, play a critical role in commercial real estate analysis. However, it’s important to shed light on how cap rates are used and manipulated, as they have both positive and negative qualities. While cap rates can be invaluable in assessing risk, there are inherent shortcomings in this metric that need to be considered. The real takeaway is understanding the process of mitigating risk.
What are cap rates, and how do they work?
In the realm of multifamily real estate syndication, the cap rate, short for capitalization rate, is a crucial metric used to assess an asset’s potential return within a specific timeframe. The formula is simple: divide the property’s net operating income (NOI) by its value. Cap rates are often viewed as indicators of risk and reward, with lower cap rates suggesting lower risk and higher value, and higher cap rates indicating higher risk and lower value. However, as you delve deeper into the financial modeling and underwriting process for multifamily properties, you realize that cap rates can be influenced by various assumptions that may impact their reliability as risk and reward indicators.
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, especially in light of the uncertainties brought about by events 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 their calculation.
Cap rates are a fundamental measure used in real estate to assess an asset’s return potential. However, cap rates can vary significantly depending on the type of property. In the realm of real estate investing, there are key differences in cap rates between multifamily and commercial properties. Multifamily properties, which consist of residential units within a single building or complex, are typically categorized as residential assets and often assessed based on market rents. They are generally considered less risky due to the stability of rental income and a larger pool of potential tenants, resulting in lower cap rates. On the other hand, commercial properties, such as retail, office, industrial, or hospitality, may have different income streams, lease structures, and operating expenses. They are influenced by broader economic factors, industry trends, and business cycles, and may have higher cap rates compared to multifamily properties.
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. This group’s overall thought processes revealed that cap rates are not just about risk assessment, but also about understanding the nuances of the market and the properties being analyzed.
The question posed was straightforward: Which is preferable, a 4% cap rate or a 7% cap rate?
The responses received were diverse, but the prevailing sentiment was that a higher cap rate was generally 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: If the property has untapped potential for value-add opportunities, such as renovations or improvements that could increase its overall value, this could lead to a higher cap rate once those value-add components are implemented.
- 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.
The integrity of the Cap Rates
The integrity of a cap rate is rooted in the data used to calculate the net operating income (NOI) of a property. 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 single-family, multifamily, or other commercial properties, can affect the cap rate. Each asset class may have different market dynamics and risk profiles.
- 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 property’s performance and cap rate.
It’s important to note that higher cap rates do not always equate to higher returns, and cap rates alone do not determine whether a property is a good deal. Additionally, rising interest rates do not necessarily result in higher cap rates, and proforma projections of rents and expenses may not always reflect the actual performance of the property.
How Cap Rates Impact Multifamily Investments
Current market report April 2023.
By the numbers: The multifamily going-in cap rate saw a 23 basis point increase to 4.72% in Q1 2023, the first significant deceleration in cap rate expansion since the Fed started its recent rate hikes. CBRE also reported that IRR and rent growth targets slowed down in Q1, indicating further stabilization
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 and operators who can 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. Remember that the data is readily available, and self-education should never be underestimated. Investing time in acquiring knowledge, cross-referencing and verifying information, and continuously learning will be key to your success as an investor.
