There is no shortage of literature and opinions on cap rates (short for capitalization rate) in commercial real estate (CRE). It’s arguably the most fundamental metric in CRE investing.

It’s fair to assume that most investors (active or passive) are investing in property for cash-flow (i.e. income). If you are buying income producing property, then cap rates DO matter. 

When I first started in this space in 2014, understanding cap rates were fundamental to being considered legitimate in CRE. You wouldn’t garner much respect from brokers if you couldn’t talk cap rates. In the last couple years, I’ve heard several discussions alluding to “cap rates don’t matter”, “we can force the cap rate down or up”, etc. which effectively negates the importance of cap rates. Since the way income producing properties are valued has not changed, I believe that some investors are ignoring the importance of cap rate given the competitive (and forgiving) market we were in. A rising tide lifts all boats and in an environment of strong rent growth and compressing cap rates, there was no foul for not considering cap rates in depth. But long-term, the understanding of cap rates is fundamental to investing in CRE and this article explains why.

What is a Cap Rate?

A cap rate is a measure of risk.

The statement above is probably not what you expected to see first in an article about cap rates. Most articles about cap rate start with defining cap rate as:

Cap Rate = Net Operating Income (NOI) / Value

The above formula tells you how to calculate a cap rate but nothing more. A property with $600K of NOI is purchased for $10M and hence has a 6% cap rate. But what does that mean? How does it help an investor make decisions?

For investors with finance experience, think of cap rate in real estate as the inverse of P/E (price to earnings ratio) ratios for equities. It provides the ability to compare opportunities against each other.

There are many variations of how cap rates are calculated; purchase, proforma, stabilized, etc. Also, there is a need to properly normalize income/expenses to get to a reliable cap rate to reflect normal market conditions. If you asked 10 people to calculate the cap rate given a set of assumptions, you’ll likely get 10 different answers. We’ll explore the different ways to calculated cap rate in another article.

Cap rates alone, cannot be used to evaluate the potential of prospective opportunities. It does not take into account leverage, future cash flows, management expertise, time value of money, etc.

But cap rates are a great measure of investment risk and understanding risk, and balancing risk and reward, is paramount in prudent investing.

Cap Rates Matter

How is Cap Rate a Measure of Risk?

All investments carry risk and it’s no different in CRE. The basics of Corporate Finance breaks down an investment return into two parts:

Risk-Free Return + Risk Premium

Risk-free return is typically considered a US Treasury Bill, given that it’s backed by the government and risk of default is extremely low. Hence, why a Treasury Bill has a very low return given it’s low risk. The 10YR Treasury is currently ~0.64%.

Risk Premium is the additional return you should attain to compensate for the additional risk you are taking on. For example, an investment in an apartment complex is inherently more risky than a T-Bill and hence, the risk premium should be higher. Average cap rate for apartments in 2019 was 5.37% per CBRE. This reflects a sizable “spread” (i.e. risk premium) over the risk-free rate.

Further, not all apartments are created equal. For example, a brand new luxury apartment (Class A) in an in-fill location in San Francisco is a lot less risky than an old 1960 (Class C) built apartment in a high crime area of Chicago. Therefore, it would be reasonable to pay a low cap rate (higher price) for the Class A property and a high cap rate (lower price) for the Class C property, to reflect the higher risk of attaining the income.

The chart below from CBRE gives a good representation of apartment cap rates, by property class, for the last 7 years. As you can see, the spread between Class A and Class C cap rates has narrowed over the years and this is really driven by the significant compression of Class C cap rates.

Multifamily Cap Rates

There are various factors that impact risk in a property and not all are quantifiable. These factors including property type, age of property, location (in-fill vs. rural), diversity of tenant base, median incomes, interest rates, market liquidity (buyer pool), etc.

Cap rates represent the market’s sentiment for taking on risk. The challenge, as an investor, is to determine the appropriate risk-adjusted return that properly compensates for the risk in the deal.

Understanding “Market” Cap Rate

I don’t believe there is such thing as a ‘good’ or ‘bad’ cap rate. Some may argue that buying a high cap rate deal is the way to get the best returns. Though it is true, in general, that the higher the cap rate, the higher the cash-flow (since your paying a lower price for a higher income stream), it may not always materialize given the higher risk. Further, it does not take into account the overall growth prospects of the area nor the business acquisition business plan (e.g. value-add) the investor intends to implement.

Buying a 2% cap rate deal in New York City could be just as rewarding as buying a 7% cap deal in Kansas City, as it all depends on the business plan and appetite for risk.

I believe that understanding the cap rate your purchasing, relative to the ‘market’ cap rate is important. This data is not readily accessible, but if you look at enough deals, talk to brokers/appraisers/lenders, etc. you can get a feel for the going cap rates. For example, in Dallas-Fort Worth (DFW), the current market cap rates for infill class A, B and C multifamily properties are 4.5%, 5.25% and 5.75% respectively per CBRE. These can vary significantly based on the location of the property as well, where a class-C deal in a higher income neighborhood could go for a 5.5% cap versus a 6.25% cap in a lower income area.

Why Does this Matter?

“Minimizing downside risk while maximizing the upside is a powerful concept” – Mohnish Pabrai

In my opinion, protecting your downside should be top of mind when making investment decisions, especially if your a steward of investor’s capital. While you can change many things on a property via value-add, you can’t change the price you pay for a property and it’s location. The allure of “value-add”, which is the ability to increase income or decrease expenses via operational/physical improvements, has caused investors to bid up prices (lower cap rate), especially in the class C/B space. But has the investment risk decreased to compensate for the lower cap rate?

I’ve seen investors buy class-C deals in DFW in areas with very low income (<$30K median HH inc) at <5% cap rates because of the potential to raise rents $150-$200 and increase the income. But is the potential return worth the risk versus the alternative to buy a nicer stabilized class-A deal, that is a lot less risky, for a 4.5% cap rate? It clearly depends on your appetite for risk and your (or your investors perceived) ability to execute.

Some other reasons why it’s important to understand market cap rates:

  • Buying at a Discount – Buying at a cap rate that is higher than the market is how you buy at a discount. And in any business or investment, buying for under market value is a sure way to increase your downside protection if things don’t go perfectly as planned. If your patient, there are always opportunities to buy at discounts, in any market.
  • Execution Risk – I’m not saying that buying a class-C at a low cap rate is a bad idea. There are investors that are very experienced in doing so and providing strong returns. But as a passive investor, would you want to invest in this type of deal with a first time sponsor? Also, what happens if you can’t raise rents $150-200/unit as planned, which could be the reality some owners face given the current (covid-19) environment we are in? You may not be able to achieve those returns so your risk increases, but you’ve paid a price for low risk (i.e. low cap rate).
  • Distressed Property – It’s fair to say the discussion to date is based on the premise of buying income producing properties, which are generally stabilized and provide a current income stream from day-1. Distressed properties, inherently, are not stabilized and do not offer a steady stream of income initially. Many of the properties purchased out of foreclosure in the last recession were bought at very low occupancy, with major deferred maintenance, etc. and were not purchased on a cap-rate basis. These types of deals resemble more of your traditional ‘fix and flip’ or ‘fix and rent’ model in that your buying now, with little current income, for the future potential to turn the property into an income stream that can be valued on a cap rate basis. This is perfectly viable business model that I think may increase in relevance as some deals struggle to recover post covid-19.

Conclusion

Though we have only scratched the surface on cap rates, the understanding of cap rates is critical to evaluating investment risk. Given the current environment (covid-19) we are in, it’s more important than ever for investors to understand risk.

As cap rates have continued to compress in the class C/B space, I’ve seen seasoned investors trading in older properties and buying newer ones. This tells me that they can’t justify the risk of buying a class-C asset at a 5% cap when they can buy an class-A at a 4.5% cap. Further, I’ve also seen investors move to different markets where they can find a risk / reward balance that is more favorable.

As a sponsor (general partner), you should be able to express to your investors how you’ve measured and managed the risk and why there is a compelling risk / reward balance for the deal.

As an passive investor, you should always ensure that you are adequately being compensated for the risk your taking on by investing in a particular deal / sponsor.

Viewing cap rates as a measure of risk enables you to do so.