If you’ve ever spoken with a commercial real estate sponsor, you’ve probably heard a lot of chatter about cap rates. By technical definition, cap rate is the net operating income (revenues minus expenses) of a property divided by the purchase price. For those more familiar with the stock world, a cap rate is essentially the inverse of a PE ratio – 5% cap rate would be equivalent to a paying 20 times earnings for a stock. In theory, real estate investors should be interested in buying at high cap rates and selling at low cap rates. Metrics like cap rates help investors answer the question: “How much am I willing to pay for the operating income provided by this asset?”
To answer that question, here are two important follow-up questions investors should also be asking:
- How consistent and/or perpetual is the operating income going to be?
- Is there an opportunity to grow the operating income? And if so, how much is it going to cost?
All too often, investors get hyper focused on a cap rate but fail to ask the follow up questions above. Consider a couple examples:
Example 1: An investor is considering investing in two single tenant retail buildings. Building A is offered at a 10% cap rate (10x earnings) and Building B is offered at a 5% cap rate (20x earnings).
On the face of it, the first option would be a no brainer – the investor is getting way more cash flow relative to the purchase price.
However, if the tenant in Building A only has 2 years left on their lease and the tenant in Building B has 15 years left on their lease, then the answer isn’t as clear. It’s very possible that Building A tenant leaves after their lease and the 10% cap rate goes to 0% until the landlord can find a new tenant – which can be very expensive. By contrast, Building B is set up to enjoy many years of cash flow.
In this scenario, asking how consistent and/or perpetual the operating income is going to be is critical in making an informed decision.
Other factors that could impact the going concern of a property’s cash flow could be the financial position of the tenant, the age of the property, the quality of the location, the potential for new supply/competition or other factors.
Example 2: An investor is looking at acquiring a multifamily building in a well-located part of town. The Seller’s asking price contemplates a 4% cap rate, which may feel a little low at first blush.
However, this savvy investor does some homework and realizes that the average rent at the subject property is $1,000/month, where the average rent at similar properties nearby is $1,250/month. Just by bringing the subject property up to the market, the investor could grow revenues by 25%, which would result in a stabilized cap rate of 6% assuming no change in expenses once all the leases have been brought to the market rate.
However, the investor must factor in the time it will take to turn leases and if there is a need to invest additional capital in the property to allow the property to achieve the higher rents. If a renovation program is required to generate the additional rent, then the more relevant metric becomes the yield on cost, which is equal to the net operating income divided by the purchase price plus other capital expenses.
In this scenario, asking if there is an opportunity to grow the operating income and how much it will cost is critical in making an informed decision.
Making reasonable assumptions about how to grow a property’s operating income is perhaps the most critical part of making a real estate investment. This growth can come in the form in increasing rents as outlined in the example above, but it could also take the form of leasing up vacant space/units or by reducing the property expenses. Whatever the strategy, it’s imperative that the assumptions made are achievable and can be supported by market data and operator experience.
Cap rates are a very important metric, but there’s more to know than just a cap rate when considering an investment opportunity. If you’re interested in learning more about how MLG is finding value and looking at cap rates in our deals, please reach out!
Nathan Clayberg is a VP at MLG Capital, splitting his time between working with investors and chasing joint venture acquisitions in the Midwest. Outside of work, Nathan cherishes time with friends and family and enjoys working on his own real estate portfolio.