How Cap Rates can be Deceiving

Most investors use cap rates as a metric to analyze a potential deal and calculate the valuation of a property. You’ll often hear investors say things like “I won’t buy at a 4 cap!” Strictly using cap rates, however, can be deceiving in substantial value add situations.

Many value add properties have a low cap rate because they are distressed. Distressed commercial properties could look like distressed residential properties – where they need significant repairs – but could also be distressed based on simple mismanagement. A mismanaged facility could be one where in-place rents are far below market, there is an abundance of vacancy, and/or there are many unnecessary expenses. Such mismanagement will drive the cap rate down. If an investor is looking strictly at a cap rate, s/he is unlikely to purchase this type of mom and pop property trading at a 4 cap.

A deeper dive, however, could illustrate a value add opportunity. A seasoned operator will feel confident in raising rents to market rates, increasing occupancy, and decreasing unnecessary expenses.

We recently purchased a storage facility in Indiana from a mom and pop operator at approximately a 5 cap. Within a few months, we raised storage rates to market, leased a warehouse that was not previously monetized, added administration and other common fees, offered lock rentals, and mandated tenant insurance. Within just a few short months, we raised the facility to an 8.5 cap valuation.

An investor should be weary about relying on broker pro formas, but not beholden to as-is numbers. To ensure that an investor’s pro forma, or even a broker’s pro forma, is realistic, investors should do their due diligence by, among other things, analyzing the market, discussing with their property manager, and analyzing the income and expense ratios of the investor’s other similar properties.

If an investor is confident that s/he can increase the net operating income from $50,000 to $100,000 it changes the tenor of the deal, and drastically changes what an investor could, and should, offer to purchase the property. Stay in your buy box, but be cognizant of the shortfalls of relying exclusively on cap rates.