The direct capitalization method is perhaps the most common metric used when discussing real estate property values. It’s a simple way to measure what investors are willing to pay for a particular asset class/property type in a particular market. Despite their usefulness and dominance in real estate conversations, cap rates have significant limitations in analyzing an investment’s true value. Here are the 4 things that cap rates are not telling you:
- Cap rates do not consider the effects of financing. Depending on the cost of debt (interest rate), financing has the ability to lower or increase an investment’s internal rate of return.
- Cap rates do not consider the tax impact of real estate ownership. There are a number of tax benefits to real estate ownership which lower taxable income and increase returns.
- Direct capitalization only looks at a one-year forecast to determine value. It does not take into account changes in periodic cashflows or property value over the life of the investment.
- The value of an investment can be distorted if the net operating income does not represent a stabilized NOI. Properties are considered stabilized once they are fully leased or have achieved reasonable occupancy based on market vacancy rates.
While they have their limitations, cap rates can provide useful information about real estate market values because they indicate how much an investor will pay for each dollar of net operating income. In general, markets defined by rising cap rates will see a decrease in property values and vice versa.