CAP Rates - Why are lower CAP rates better?

Question

Hello real estate family, I have done commercial real estate and landing banking in Mexico (Riviera Maya) for 12 years and now I am getting ready to move my portfolio to the US (I´m from Rhode Island originally) into Multi Family. It is a cash market here in Mexico so I am new to traditional lending / leverage and some of the rules of thumb hence CAP rate ...

I am left confused as to why a lower CAP rate is better than a higher CAP rate. I understand that there may be more room for growth (larger margins due to increased rents and appreciation on lower valued property) but thats it. Essentially, if your CAP rate is HIGHER then your NOI is higher which in turn means you are receiving a higher percentage of net cash flow annually. Why would a lower CAP rate be better when you are receiving a less profit annually?

So if a CAP rate helps indicate the rate of return that investors can expect to generate on an investment property why would the lower the rate of return be better?

Austin Andrews · Answer

As stated above, cap rates are basically what you are buying the property for compared to its NOI, and the risk associated with that investment. In St. Louis, Central West End (Highly desirable, high income area) is around a 5-6 cap rate (could be higher or lower, depends on the property). Higher crime and low income areas could be 10-13 cap rate (higher or lower, this is just a range).

What you need to be looking at, is how to increase the cap rate for you. Can you buy a 6 cap rate property, increase it to a 10 cap rate according to YOUR purchase price and the new NOI, then resell at a 6 cap rate, making a hefty profit?

An example: Buy a 5% cap rate deal for a million. It should have an NOI of 50k based on the numbers. Raise that NOI to 75k. You now have a property with a 7.5% cap rate. If you sell it at a 5% cap rate, your property is now worth 1.5 million. You raised the NOI by 25k and made 500k in the process.

John Warren · Answer

@John Erlanger I always look at the NOI that is in place by which I mean the current NOI. This looks at how the property is performing for the seller as of right now. I also will look to see if I can add value and increase the NOI in the future. This gets me a pro forma NOI. The delta between the current NOI and the pro forma NOI is where I get excited when I am doing a deal. This is where I can add value. I am doing a deal now where I can take the NOI from around 50-60k (unclear due to very poor seller records) to around 110k per year with my pro forma. I will do this by executing my business plan which is a heave value add strategy. This will allow me to increase the value of the building by around 800-900k!

The thing with any of these financial metrics is that they are a snap shot in time. Things can happen to change the NOI and we can increase the NOI (or mess up and decrease it through poor management).

Russell Brazil · Answer

They are not better or worse.

Cap rates are a function of risk.

Lower cap, lower risk, higher cap higher risk.

Do not confuse risk with a sentiment of good or bad though, risk is neither.

Anthony Thompson · Answer

@Ryan Gravel lower cap rates are better if you're a seller, because it means the buyer is paying you more money for the same amount of net income from the property.

Lower cap rates are worse if you're the buyer, because it means you're paying the seller more for the same amount of net income (i.e., getting a lower return).

It's all a matter of perspective 😄

Anthony Thompson · Answer

@Ryan Gravel I think that's only loosely true. I think cap rates have much more to do with prevailing market conditions (general supply and demand) and less so with "risk".

It's a tricky question, because there's general "risk", such as the fact that nicer properties have less chance of tenant problems, so there's less risk of hassle and therefore people are willing to pay more which results in a lower cap rate.

But there's also specific property risk, such as if a particular property has features that make it more risky (e.g., a recent fire, or structural issues that were only partially/poorly repaired) or less risky (recently constructed by a building of good reputation). So obviously that would affect the price (and thus, cap rate) for that specific property.

Generally speaking, real estate has aggravation and the "risk premium" component of the cap rate is already baked in (i.e., people expect a little better return vs. other investments because of that). But I personally feel it's not a huge proportion of the cap rate - my guess would be that a much higher proportion of cap rates (a much bigger component of the overall cap rate) is due to the illiquidity of real estate.

As far as the fluctuating nature of cap rates from year to year though, I do feel that's mainly due to market supply and demand, since the risk premium and illiquidity premium are basically baked in and don't change; it was just as inconvenient to lock your money up with a long term mortgage/property ten years ago, and just as much hassle to deal with tenants (directly or indirectly, via property management delegation) as it is today.

There are lots of Wall Street inspired/funded studies that research these somewhat theoretical questions. But at the end of the day, it comes down to how much do you want a particular property, and how much does the seller want to sell, that determines your price and thus your particular cap rate.

I find such studies personally interesting, but think most investors would be much better served spending the same amount of time investigating ways to improve their negotiating skills, than understanding the finer points of the cap rate components 😂

Ryan Gravel · Answer

@Anthony Thompson thanks for your response and your reply makes perfect sense to me. I guess what I am finding is more related to risk. In theory, a higher cap rate means a higher risk investment. A lower cap rate means an investment is less risky. This is where I’m thrown off ...

John Warren · Answer

@John Erlanger you can definitely have an as is cap rate and then calculate a pro forma cap rate. There is also the market cap rate that brokers use to price deals. All three ways of looking at a deal.

John Warren · Answer

@Ryan Gravel I think the big problem when discussing cap rates is that we confuse two concepts. One is the actual cap rate of the property based on how it is or will perform. I always run an as is cap rate analysis and then a pro forma cap rate analysis for after I have executed my business plan.

On the other hand you have the market cap rate. The market cap rate is more of a view of how people view the risk in an area. For instance town A is a 5 cap, town B trades at a 6, town C trades at a 7 and town D trades at an 8. Newer investors think town D means higher returns whereas the best returns are probably in B or C. Brokers have to give a higher cap rate to an NOI based on how risky an area is which equals less value for the seller.

Then it gets even more complicated. When you look at an OM (especially on smaller deals that aren't 100 units or more) you are missing TONS of expenses. I have NEVER seen a line item for pest control, yet all of my buildings in Berwyn and Cicero have had ongoing exterminator expenses due to cock roaches. You won't find that one on the pro forma! I recently checked out a broker's OM for a deal in Belmont Craigin neighborhood in Chicago. The building has a boiler and is a vintage courtyard building and the expense ratio came in at 33.5%. I think it will be closer to 60%!

Mark H. Porter · Answer

Yeah, where did you hear that?  I never have.

Brian Garrett · Answer

A lower cap rate is only better for the buyer in a value-add play where the increase in NOI will have a greater impact on the value of the property ultimately leaving you with a higher equity capture. Otherwise a higher cap rate is always better for stabilized deals.

CAP Rates - Why are lower CAP rates better?

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