THE TRUTH ABOUT CAP RATES

I realized this we investors (including myself) puts too much importance on the cap rate.

The cap rate is defined as, "used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is computed based on the net income which the property is expected to generate and is calculated by dividing net operating income by property asset value and is expressed as a percentage. It is used to estimate the investor's potential return on their investment in the real estate market." This definition Investopedia assumes that you paid cash for the investment property.

If you are using financing on the multi-unit property like 99.99% of investors then the amortization and rate will affect your ROI. Therefore , if you are using financing the less important is the cap rate. ROI is a more important indicator if it's a good deal.

My team was looking at a deal where the seller wanted $1.25M. The cap rate was 6%. Average cash on cash returns currently is 7%. Financing is 4% and 25 year amortization . At 6% cap the value of the property is $1,045,000.

I incorrectly thought that as long as you bought the property for the 6% cap rate value of $1,045,000 then you would get 7% coc roi. However, when I finished the underwriting I learned that to get 7% CoC ROI we had to offer $900k.

In conclusion, ROI is a clearer indicator of whether you should purchase the property rather than cap rate. Just because you buy a property for the cap rate value doesn't mean you'll hit the market cap rate.

Just be prepared to walk away from a deal when the broker or seller says that the value of the property is net operating income divided by cap rate, and you try to explain to them that you have to hit your ROI, but they won't budge.

Moving forward I will tell the seller or broker that I care more about ROI then cap rates. Lesson learned !