You Know What Really Grinds My Gears? (Cap Rate Edition)

grinds my gears

You Know What Really Grinds My Gears? When people tell me they want to invest in real estate… and are looking for a property with a(n) “X%” cap rate.

“Why?” you ask.

Without even going into cases where the cap rate they’re looking for amounts to a needle in a haystack in the market(s) they’re interested in (DC multi-family properties have been trading as low as 4.5% cap rates), the statement shows a fundamental lack of understanding of basic real estate investment principles.

Cap rates are a way to measure the market value of a property as opposed to the investment value (see my article, Market Value vs. Investment Value: What’s the Difference?).  The difference is subtle and can best be understood by which side of a real estate transaction you’re on: Buyer side (Investment Value) vs. Seller side (Market Value).

Sellers want to sell their properties at the lowest cap rate possible because if NOI remains constant a decrease in the cap rate will increase the market value of the property (the price that a property can yield in an arm’s length transaction). As demand increases for a particular asset type and supply remains relatively constant, buyers are willing to pay more for an asset or, better stated, a greater amount for the income that asset generates. As a result, decreasing cap rates function as a type of inflation on the net operating income that a property produces; decreasing the value of each dollar by requiring a lower return. Therefore, the seller’s focus is on the market cap rate, as determined by comparable sales, which sets the market value for the property based on its net operating income.

Investment value is a matter of perspective and subjective to each investor. It refers to the value that a particular investor is willing to pay for a property and is based on their required return NOT cap rate. I discuss the differences between cap rates and internal rate of return in depth in my article, Cap Rate vs. IRR: What’s the Difference?, but in short because cap rates only consider 1-year of NOI and thus do not account for changes in net operating income over the holding period, the effects of financing, or the tax benefits associated with real estate ownership they are an insufficient method of assessing value for the investor.

Real estate investors should be able to clearly articulate their required return (or range) in order to purchase an asset. They speak in terms like internal rate of return (IRR), yield, cash-on-cash, etc. Sophisticated investors understand that the use of financing can increase a property’s return through positive leverage (where there exists a gap between the cost of funds and the properties unleveraged return/cap rate). They are also aware of the tax benefits of real estate ownership that can also increase returns by lowering taxable income.

If a buyer can’t differentiate between a return and a cap rate they’re not a real estate investor. True real estate investors understand that cap rates tell only part of the story and that investments must be analyzed over the entire holding period with considerations made for potential changes in NOI through annual escalations, increased market rents, vacancies, etc. The purpose of investing in real estate is to make money. If a buyer is talking about cap rates they’re focused on the seller’s return, not their own.

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