The Cap Rate Is Dead, Long Live the Cap Rate!

The cap rate is the single most abused and misunderstood metric in commercial real estate. It’s shocking  how newbies and experienced investors alike continue to refer to it as the be-all-and-end-all metric.

The cap rate is nothing more than a measure of value at a moment in time. That’s it! It doesn’t convey any more or less information than that.

If anything, it’s highly sensitive to the vagaries of the market. It suffers, like all metrics used in isolation, from severe limitations. It can vary for reasons as diverse as location, crime, infrastructure and long-term vision for the area.

The cap rate measures a stabilized property’s natural rate of return for a single year without considering debt on the asset. In other words, the unlevered rate of return.

Example:

$1,000,000 (Property value) x .05% (CAP rate) = $50,000 year/unlevered rate of return.

How Many Investors Are Buying Commercial Real Estate Assets for Cash?

Less than 1% (ok, I made that up).

The rest of us use a healthy dose of financing to acquire assets. Hence, any metric that does not take into account after debt-service returns is meaningless.

I understand the rationale that the valuation of the asset is separate from the financing layered on it.

I get it. You get it. But the average investor using cap rate analysis to value properties DOES NOT get it.

Is a High Cap Rate Better?

Obviously, investors prefer a higher return which is loosely translated as a higher cap rate.

But instinctively, we know that high cap rate properties are also lower quality properties. In other words, the quality of the asset is inversely proportional to the magnitude of the cap rate.

Therefore, the cap rate is a measure of the risk in a deal.

It becomes imperative to understand the risk-adjusted-returns to adequately compare against opportunities and across markets.

Assets located in primary coastal markets in the United States and other global centers like London, Tokyo and Hong Kong all have global investors clamoring to purchase the limited amount of assets that exist in those markets.

As a result, they are considered extremely liquid investment markets. The amount of investor demand in these markets places upward pressure on prices leading to low cap rates.

These markets also tend to have strong economic growth factors that make it possible for owners to increase their rents, relative to market, with weaker fundamentals.

This is why assets in New York City with 4% cap rate could increase yield to 6-8% and appreciate significantly in value. Conversely, in markets like the Midwest, where liquidity and economic growth prospects are low, investors need to ensure that they receive more of their return from the yield. This is because the chances for value appreciation are low.

At Boardwalk Wealth, for our preferred niche – value-add large multifamily – cap rate analysis is, relatively, meaningless.

We are selectively acquiring distressed assets where we expect low cap rates either because of mismanagement, deferred maintenance or market positioning concerns.

Plus, cap rates only apply to stabilized properties. The value-add multifamily assets we are acquiring have not hit their best and highest stabilized level. Hence, why we buy them!

Repeat after me: Cap rates only apply to stabilized properties.

Or in other (easier words): Don’t apply cap rate analysis to non-stabilized properties.

As investors, we are looking to increase the cap rate after purchase. This is because we are looking to increase value through forced appreciation.

The fundamental question we ask ourselves is: “How quickly can we increase the yield (or cap rate)?”

This poses a conundrum.

The seller wants the property to be valued at the lowest possible cap rate. The buyer wants the property to be valued at the highest possible cap rate.

Who is right?

Neither! Because a valuation based solely off a purely hypothetical, and easily manipulated, metric is meaningless.

Valuation, to a certain degree, is still done by comps. You don’t agree?

Then why does every broker’s sales pitch on a value-add asset goes like this:

“Yea I know this asset is underperforming… but look at the comps! Everything around it is worth so much more. Presto! This asset value is a lot more. (Forget about the cap rate valuation method.)”

It might not work on you because you are a smart, intelligent and conservative investor. But we all know not everyone is like you, dear reader.

This approach works on the vast majority of the non-sophisticated investors.

Eventually, what all the cap rate junkies end up doing is comparing against comps to get an estimate for fair market value.

Our point is simple: Why give importance to a meaningless metric when you’re going to be relying on comps analysis?

The Reversion (Exit) Cap Rate Saga

The conservative sponsor should use an exit cap rate 50-200 bps higher (depending on the market) than acquisition cap rate for value-add multifamily deals.

But what happens when an asset is acquired for below-market cap rates?

The typical sponsor using the 50-200 bps range estimates the wrong terminal value.

Mr. Market does not care that an asset was acquired at below-market cap rates. It will price the asset at the prevailing market rate.

The market giveth and the market taketh. Long live the cap rate!

Opposites Attract: IRR or Equity Multiple

The higher the reversion cap rate, the lower the estimated exit proceeds and the lower the IRR/equity multiple metrics.

This is where sponsors start gaming the system and investors must start peeling back the layers. The IRR is dependent on many factors, including:

• Purchase price;

• Exit price (biggest contributor to terminal value calculations);

• Rent growth;

• Forced appreciation potential; and

• Debt terms

As a result, it is easily gamed because a slight movement of the reversion cap rate can dramatically change project level estimated results.

This is where other metrics like equity multiple and discounted cash flow analysis (DCF) comes into play.

Equity multiple is the true indicator of wealth and not as easily manipulated as the IRR.

In simple terms, the equity multiple tells an investor what they make for every invested $. No discounting, no fancy math… just a pure, nominal number.

It also has an inverse relationship with IRR because it is not time dependent.

The longer the time period, the smaller the IRR but the higher the equity multiple.

But most sponsors are compensated on hitting IRR targets.

So what do you think happens?

Sponsors start playing the IRR roulette. In other words, how quickly can the IRR be forced up and the property “flipped”.

The DCF is the gold-standard but least used measure of valuing commercial real estate assets. It is the foundation for valuing all financial assets. The basic concept is simple: the value of a dollar today is worth more than a dollar in the future.

The value of the asset is simply the sum of all future cash flows that are discounted for risk.

The timing of the future cash flows and the likelihood they will occur greatly influences the price an investor would be willing to pay for an asset today. Riskier cash flow streams are discounted at higher rates and vice-versa.

If a cash stream has a 100% chance of occurring (e.g. coupons on government bonds), then the returns an investor will require will be far less than the return on an uncertain income stream.

DCF is more a comprehensive and accurate way of valuing an asset. It’s also the least used method.

I get it. Simplistic cap rate analysis is alluring. But investors, like Odysseus, must resist the siren song and seek safety through more robust analysis and refuge in more meaningful metrics.