P/E ratios vs Cap Rates as metrics

[Jeff B.]

Stocks are measured using a Price / Earnings ratio
(ref: http://www.investopedia.com/university/peratio/peratio1.asp)

• Although a simple indicator to calculate, the P/E is actually quite difficult to interpret.
• It can be extremely informative in some situations, while at other times it is next to meaningless.
• As a result, investors often misuse this term and place more value in the P/E than is warranted.
• A P/E of 20 indicates an investor is willing to pay $20 to get a $1 return (a 5% return).
• The earnings (or returns) come to you as dividends and are distributed quarterly (in the U.S.)
• Two obvious problems with the metric:
• Speculation can drive the Price skyward irrationally, distorting the real meaning.
• A company over extended or facing declining market for their products does the same.
• An overly exuberant P/E is therefore suspect

REI Cap Rates

• Simple to calculate: NOI / Purchase Price(PP)
• The Cap Rate operates in parallel to the P/E ratio discussed above and has similar issues.
• A Cap Rate of 5% says the investor is paying $20 in price to buy $1 of NOI
• However, the NOI is not the same as the P/E earnings; NOI needs to be adjusted by the mortgage to evaluate the Cash-Flow: NOI - Mortgage Payment = Cash Flow.
• Cash-Flow is the residual you keep after paying the bills monthly.
• It's easy to create an overly exuberant NOI, insufficient due diligence to disclose ALL the true expenses or by quoting Pro Forma rents which are unrealistic for the property.
• Unlike stock speculation, REI speculation on FMV will inflate PP upward and Cap Rates down.

As shown, the Cash-Flow is a much better indicator of a property than a Cap Rate
but it is more difficult to derive as it depends upon an unknown, the mortgage payment
and that has other economic considerations. The Cap Rate is therefore an off-the-cuff number that
is easily derived an can be used as a comparator when comparing various properties.