Cap Rate, Important or NOT?

Question

As a value-add investor, cap rate is not a main focus of ours when evaluating an exit.

We do not control the market and neighborhood cap rates when investing in multi-family. We can still manipulate the NOI based on our underwriting, but no control over the cap rate.

How important is cap rate to you? Do you use it? Does it matter?

If cap rates are important I would love to know how the rate factors in your underwriting and how it assist in your overall evaluation.

Aaron K. · Answer

Cap rate is important because not only does it determine the return if you are holding but determines the value when you look to sell.  If you are a value add investor, the property didn't increase in value because you made it pretty, the property increased in value because you are able to charge more rent by making it pretty.

Brian Burke · Answer

Cap rate is very useful when underwriting an acquisition, but just not in the way that people think it is.  What people do wrong is they try to work the cap rate formula backwards--dividing the NOI by a cap rate to arrive at a purchase price.  That's an improper application of cap rate.  Cap rate is a way to compare the value of an income stream.  In other words, to measure market sentiment.  That's it.  It is not a measurement of the performance of the acquisition, nor a way to predict the returns.  And it's especially not a way to calculate a purchase price.

So how is it important to establishing a purchase price?  Well, setting your purchase price is a matter of finding a price that delivers the returns you are looking for.  Part of that return comes from the sale of the property.  You can't calculate the sales proceeds if you don't calculate the exit price.  The only way to estimate a resale price is to apply a cap rate to your forecasted income in the year of the intended sale.  Of course, determining what that cap rate should be is an entirely different discussion...

Account Closed · Answer

@Fletcher Clardy I do not care what the as-is CAP rate when I’m buying since I’m adding value and growing the NOI.

However, I do care what the appraiser will use as a market CAP rate when I’m refinancing or selling as that will determine the value.

Fletcher Clardy · Answer

I love the reference to the weather @John Corey. We definitely cant ignore it, nor do we have any control over it but with sound research we can determine the anticipated cap rate based on the market.

Thanks for your input

John Corey · Answer

Brian's point is a good one. Cap rates are what the market thinks of an asset class (hotels, MFR, office buildings) in the local environment and given a prevailing interest/inflation macro environment. If interest rates are rising (the Fed interest rate; not rate you pay on a loan), the market will be expecting a high yield from all RE. People with cash will consider bonds, real estate, etc when looking at passive investments. There is a ladder with the USA Treasuries and USA bonds at the low end and higher risk, less liquid investments at a higher rate (a cap rate is the RE term).You can not ignore cap rates when buying and selling a commercial property. While you might be adding value and other ways improving the deal, the eco system the property exists in still matters. A well structured deal with great up side is fine. Just remember that the financing and the exit will still take into account the cap rate. You could say the cap rate is like the weather. While you can not control it the current or future weather will still have some sort of impact.

Nicole Heasley Beitenman · Answer

I have a mortgage on all my properties, so cap rate doesn't matter to me. I look at monthly cash flow.

Travis Watts · Answer

@Fletcher Clardy Good point. It's definitely not the most important metric to look at. As a limited partner in syndications, I consider first the team and their experience/track record and I compare that to what will be required in the "value-add" business plan. Typically I stick to Class B value add investments that cash flow from day 1 and do not require extreme heavy lifting. The second metric I consider is the overall market; whether or not it is expanding and what job diversification is in the area. Last, I consider the deal metrics such as cap rate, loan type, purchase price etc.

Bjorn Ahlblad · Answer

@Fletcher Clardy to some investors it seems really important. For me I look at all aspects of the deal and especially how can I reposition the property for a better utilization. So that would mean 2 different cap rates anyway.

Most of the time seller cap rates are miscalculated. So I certainly consider it; but don't base my buying decision on it.

Tj Hines · Answer

@Fletcher Clardy We take a look at cap rates as to justify what other buildings are trading for. If we can improve operations, the cap rate will follow. The way we offer if we get a deal that pencils and we win it were typically not buying at the market going cap rate. We are buying on a better cap based on our analysis. We do want to know what the CoC return is looking like. This is the cash flow. This is the reason why we buy these deals. Strong cash flow from day one is a plus. To some it may not be as they buy distressed which will take some time to stabilize the asset.

We estimate 50-75 basis pts higher on the exit assuming the market will be worse at that time

Fletcher Clardy · Answer

Account Closed thank you for your input. We typically try to use the same appraiser for our local investments, this way we understand the process and typically can guess what rate will be determined.

When working in our Southeast markets we tend to do more due diligence to select an appraiser since some investors will use cap rate to determine the value.

Cap Rate, Important or NOT?

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