When Cap Rates Don't Matter

Most investors use cap rates as a metric to analyze the offering price and valuation of a property. Strictly using cap rates, however, can lead you to miss substantial value add opportunities.

Many value add properties have a low cap rate. For example, the cap rate of a mom and pop owned property may be driven down by below market rents, vacancy, or unnecessary expenses. If an investor is looking strictly at a cap rate, s/he is unlikely to purchase the 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. These changes can take a property from a 4 cap to a, pro forma, 10 cap.

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.