Is the cap rate really a reliable estimate of risk?

Question

I'm new to the REI world and still learning the basics. Something I'm trying to wrap my head around is whether the cap rate is actually a reliable indicator of the risk of an investment. My understanding is that the metric itself is simply the ratio of NOI and cash purchase price, and a higher cap rate generally indicates more risk.

However, it seems like there are so many factors that could artificially inflate/deflate the cap rate for a particular property. For example, let's say I find a MFH for sale and successfully negotiate the price down by 20% (probably a great deal!). My cap rate just increased by 25%, but certainly my risk did not change? I can imagine that if you look at large markets over time, these effects average out and you can get some snapshot of the risk in that market. But when looking at the cap rate of an individual property, I am having a hard time trusting the usefulness of the metric.

Similarly, there are so many factors that I would think influence the actual risk of an individual property. Things like age, condition, location, financing conditions, etc. All these considerations are lost information when looking at individual cap rates. Yet it seems like such a commonly used/talked about metric.

Anyone have any insight? Anyone know of any studies that have looked at the relationship between the observed cap rate of a large group of properties and their actual investment performances to see if cap rates actually correlate with risk/performance on an individual basis?

Immanuel Sibero · Answer

@Katie Koehler

Good question! There is a lot of misconceptions around cap rate. Just do a search on "cap rate" here on BP, you will get an idea.

The cap rate that you mentioned in your post is the individual property cap rate. It is really useless (as you found out). Yet a lot of investors (even experienced ones) use it as a performance metric but it really is not a performance metric (at least not a good one, IMO). It is even more of a farce to use an individual property cap rate to measure risk. That's why you can't get your head around it. You gave a good example of how a negotiated price will ultimately change the property cap rate and thus change the risk, which is a ludicrous concept.

The cap rate as a measure of risk that you read about here on BP really refers to the "market" cap rate. Even then, this "market" cap rate is more of a value metric than it is a risk metric. This "market" cap rate is the one you should understand. But before understanding this cap rate as a measure of risk, you should understand it as measure of value first (value and risk go together anyway). "Market" cap rate is a blended (estimate) cap rate based on all the cap rates of the comparable properties that had recently sold in a particular local market. When you're interested in a commercial property in a certain market, you would need to talk to the local brokers, lenders, property management, to get a "market" cap rate. Again this is a blended cap rate for the market, NOT an individual property cap rate (you haven't bought a property yet).

Let's say, by talking to some brokers you find out that the prevailing market cap rate is 5% which means there have been some similar properties that had recently sold at 5% cap rate on average. A market with 5% cap rate tells you that investors are willing to pay $20 for every dollar of NOI. So any comparable property in that particular market with NOI of $100,000 will be roughly valued at $2Mill. Another way of looking at it is investors are willing to pay 20x NOI in that market, this maybe because the local economic prospects are good and better demographics of people are moving in. This is why some experienced investors describe this cap rate as a general measure of market sentiment (how confident they feel about the local market outlook). The more confident the investor feel about a particular market the more they are willing to pay for NOI. If one investor decides he is very confident / bullish enough about the market he may bid up and offer 25x for NOI which translates to 4% cap rate. In this case cap rate is said to have compressed.

So how does all this relate to risk??? Well, in the same way you may find another market where the "market" cap rate is 20%. A market with 20% cap rate tells you that investors are willing to pay only $5 for every dollar of NOI. So any comparable property in that particular market with NOI of $100,000 will be roughly valued at only $500,000 (only 5x NOI). Why are investors only willing to pay 5x of NOI??? Because the market has worse demographics (i.e. low income), local economic outlook is rather bleak. This is the type of market where investors feel that the market is riskier to invest in (i.e. higher vacancies, turnovers, and riskier demographics).

To answer your specific question-

Is individual property cap rate a reliable measure of risk? Don't even think about it.

Is market cap rate a reliable measure of risk? Not really.

Cheers... Immanuel

Jaysen Medhurst · Answer

A few things here, @Katie Koehler.

• Cap Rates only apply to commercial properties (5+ units in the case of MFR). They have no bearing on the value of 1-4 unit properties. For that reason they have little utility when it comes to residential properties, other than an internal metric for you to use when comparing potential investments.
• You asked if Cap Rates are "a reliable indicator of the risk"? No, not necessarily. They are a reflection of investors' judgement of risk and reward (the reward part is usually first in line with investors), which can obviously be wrong. For example, during a bubble Cap Rates fall as investors try to get in on a hot market with hopes of strong returns. Of course, in the lead up to when the bubble bursts there is actually more risk, despite the compression of Cap Rates. As you can see, not very reliable.
• It's more instructive to use Cap Rates as a reflection of relative risk between assets, especially within the same market.
• In your example of purchasing a property for 20% below FMV you wrote, "certainly my risk did not change." I disagree. At FMV that property has the same risk as other similar properties in the area (all things being equal). If you are able to purchase at 80% of FMV, there is a reason. Usually, the property is distressed for some reason: needs work, title issues, etc. The issues you need to solve in order to get the deal is where your additional risk lies. No one sells a property for 20% below market for no reason.

BTW: what part of CT are you in?

Jaysen Medhurst · Answer

@Katie Koehler, welcome to CT! It's really a great place to live and raise a family.

@JD Martin did a good job of explaining why cap rates only apply to commercial properties.

JD Martin · Answer

Cap rates don't apply to residential units because they are largely purchased by people to live in them, not use them as investments, which can severely skew the numbers. Plenty of people who want to be homeowners are willing to pay a premium for quartz countertops, teak floors, and other things that have little bearing on the profitability of a property. Commercial property - larger multi-family, etc - is essentially purchased only to make a profit. With commercial properties, your pool of potential buyers is limited to investors, whereas anything that's SFH and similar is heavily skewed towards residents.

Steve Morris · Answer

Cap Rates are a metric and an indicator of performance.  Like buying a car, people like MPG and want a high number.  But some people like SUVs that carry 10 kids to soccer practice also.

My issue with CapRates is reporting bias.  Are they based on real or ProForma numbers?  Did the seller/Buyer/broker calculate them since they all have a bias?

In reality, as far as curve fit, $/Sqft is pretty accurate assuming you've controlled for variables like condition, age and location.  If nothing else, you know the price and you know the SqFt with pretty high accuracy.

As far as risk, however, that's not really quantifiable outside of consistently higher CapRates may reflect what people think about the property and how much they'd be willing to spend on it.

Steve Morris · Answer

"The lower cap rate on the new building is consumate with the lower risk, because its brand new and will have leas operating and cap ex costs, and because its going to attract a lower risk tenant base."

I don't know if I agree totally. using your example, new const with a ton of studios downtown sells at 3% CapRate because it's bright and shiny.  Lower rent stuff in East Portland sells for 7% because its not bright and shiny.

You make more per dollar in East Portland because those always rent and you got more for your money - The goal of all investments.

In downtown Portland, we have a ton of $1400/month studios languishing = No income.  You're going to have a lot more downside risk in the pricing of those buildings than East Portland.

My point is CapRate (with all it's flaws) reflects current income.  Risk is forward-looking and dependent on a lot of variables you can't capture with just current income.

However, I'd say higher CapRates may reflect some perceived risk, but that's not what they're designed for.

Risk is more reflected in CapRate compression since those downtown units are going to need to sell for less unless there is some big change in rent-ups.

Russell Brazil · Answer

All those other things you mentioned are going to be captured in the cap rate.

Imagine this scenario. 2 buildings right next to each other, one is Class A and 1 year old, thd other is class C, 70 years old and falling apart. The market is going to value that class A at 4% and the C building at 7% (Im using made up numbers). The lower cap rate on the new building is consumate with the lower risk, because its brand new and will have leas operating and cap ex costs, and because its going to attract a lower risk tenant base.

Steve Morris · Answer

"you mentioned that cap rates only apply to commercial properties. What's the reason for that?"

In OR and just stating usual/customary.  If we call 4+ units commercial, you'll get an appraiser that'll look at them for income.  They'll use a CapRate as the metric to measure that income.  They'll report comp sales as generating income as reflected by CapRate.

Comm brokers, again by custom/usual, report CapRates in big letters on every listing.  Buyers are now trained to look to CapRates as a comparative metric.

As above, I don't like CapRates since they have a lot of variability.

On 4 and under units (I'm going to assume we're calling those NOT commercial) custom is to use either GRM/GIM, $/unit or $/SqFt, which may not be indicative (since it doesn't account for expenses) but is easy to calculate and what resi brokers use.

Katie Koehler · Answer

Thanks everyone for the info and great points! This really helped clear things up for me. It certainly seems like people apply the term and concept inappropriately.

@Jaysen Medhurst, you mentioned that cap rates only apply to commercial properties. What's the reason for that?

Let's say you were to use the market cap rate in an area to estimate the value of a particular non-commercial MFR based on its estimated NOI (value = NOI/market cap rate in this case). Would that be a useful way to compare the price of that property to its expected value in the market?

And I just arrived in West Haven!

Is the cap rate really a reliable estimate of risk?

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