We are grateful to have the opportunity to republish an exceptional post provided by RealtyMogul.com.  This post, CRE 101 Part 2 discussed the shortcomings of CAP Rates. While I enjoy sharing my commercial real estate investing insights and have blogged about how to conduct due diligence, Realty Mogul’s expertise is well worth sharing with you. Enjoy.~Robert Kantor

CRE 101: The Shortcomings of CAP Rates 

When purchasing commercial real estate, using Cap Rates (determined by dividing the net operating income by the asset’s value) may be helpful, but also potentially misleading if relied upon too heavily. The following details some of the shortcomings of only using the Cap Rate to decide if an acquisition target is competitively priced relative to the rest of the market.

1. The Net Operating Income (NOI) Can Be Calculated in Different a Way 

The Cap Rate is a relatively easy calculation (NOI/Value = Cap Rate), but problems can arise if different ways of calculating net operating income (NOI) are used.² The NOI may be calculated using the last twelve months of actual income and expenses of the property, which means the calculation looks backward and therefore may be outdated if the property’s performance is improving or declining.³ To avoid using outdated information, some will take the last month or three months of a property’s operations and annualize the income to calculate an NOI that reflects a property’s updated performance.  Still, others will look forward to how they will personally operate the property and will calculate the NOI with revised figures that may include projected reductions in expenses, or increases in taxes, or improvements to occupancy or rental rates.  If one individual includes in their NOI above the line reserves and anticipates paying property management fees to a third party out of expenses, the resulting Cap Rate will be far different than if another individual calculates NOI by putting reserves below the line and planning to self-manage.? Because the NOI can vary depending upon how it is calculated, the use of a Cap Rates may be inconsistent and unreliable for comparison purposes.

2. The CAP Rate Reflects a Limited Period in Time 

When determining the Cap Rate, twelve months of net operating income is used. This means that the Cap Rate may only reflect a specific period in time when the income of an asset may be uncharacteristically high or low. For this reason many real estate professionals may also look at several methods of calculating net operating income in order to see how the asset is trending (annualizing the last 3 month or 1 month of property performance) and/or what the Cap Rate will be under different performance scenarios (increasing rents, reducing vacancy, removing property management, etc.). The Cap Rate calculation alone does not tell the story of whether the asset is improving or declining in performance. It merely shows the return or value based upon one 12-month income scenario, which may have already changed since the data was gathered.

3. The CAP Rate Doesn’t Include Any Mortgage Payments  

The net operating income used to calculate the Cap Rate reflects the property’s gross income less expenses but does not include any mortgage payments. Many buyers plan to put debt on commercial real estate throughout the hold period. The fact that the Cap Rate does not include the debt financing, which may be as much as 70-80% of the value of the asset, may limit the usefulness of the metric for buyers who plan to use financing.

4. The CAP Rate Doesn’t Reflect Expiring Leases  

Cap Rates can be difficult to use for single tenant assets as the value of the property may be directly tied to the anticipated cash flow from the remaining lease terms. For example, if two Dollar General stores are both selling for a 6% Cap Rate, and one has 20 years left on the lease and the other has 2 years left on the lease, the Cap Rate doesn’t indicate why the two assets have a similar unlevered yield when one has a maturity coming up and the other does not.? Without having the leases in hand, a buyer might see the Cap Rates and assume a similar risk/return profile.

5. The CAP Rate Does Not Determine if the Property is Offering a Risk-Adjusted Return 

A buyer may assume that a relatively low Cap Rate (3-5%) means the asset is high priced and therefore safe, or that a relatively high Cap Rate (8-10%) means the asset is low priced and therefore somewhat risky. This is not always a correct assumption to make when looking at Cap Rates. While major metropolitan areas like New York, San Francisco, and Los Angeles are known for having assets that sell at low Cap Rates, a low Cap Rate in a tertiary market could either mean that the asset has a long term corporate guaranteed lease (i.e., a Walgreens or other AAA-rated tenants) or that the asset is half empty and therefore not stabilized. Alternatively, an asset may sell for a high Cap Rate if the seller is distressed or if it is in a market with low risk and without a significant amount of expected appreciation, like a Section 8 government subsidized housing project in a secondary or tertiary market. In short, a “high” or “low” Cap Rate is not always a direct indication of the asset’s risk profile.

6. The CAP Rate Assumes a Stabilized Asset 

Cap Rates are intended to be used to compare stabilized assets to other stabilized assets in a specific market. As a result, a Cap Rate is not useful for comparing value-add transactions which have below-market rents and/or occupancy. Cap rates assume that all of the properties in a comparative set have near market occupancy, market rents, and expense factors in order to create a baseline average capitalization rate for the market. For example, stabilized 1980s vintage class B unrenovated apartment buildings with less than 100 units in a submarket should only be compared with other like properties that are functionally the same.

Cap Rates can be very helpful to compare a group of similar sales in a market, or to do a quick calculation to determine an asset’s value at a high level. However, due to the limitations of Cap Rates, investors should be aware that the Cap Rate alone should not be the deciding factor for buyers to decide to invest in a commercial real estate transaction. The Cap Rate is one of many metrics that help analyze the property’s overall return profile. The next article in this series describes why the Cap Rate should never be used when looking at value-add transactions.

Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.

To learn more about the possibility of earning long-term, reliable cash flow with Headwater Capital, contact Robert at RAKantor@HeadwaterCapital.com.