OK. Fine. Cap Rates and COC are not worthless. But, they are almost worthless in reality — and totally worthless the way you are being taught to use them. That, and I needed a title that’d catch your attention because this stuff is important!
What IS Cap Rate?
Capitalization Rate is a metric that tracks behavior of the marketplace as it relates to risk appetite. Note, we are talking about behavior, marketplace, and risk, and we are not talking about property valuation. So, let’s talk…
Everyone is familiar with something called Comparative Market Analysis (CMA). The CMA is a method of estimating the value of a single family structure by comparing it to similar properties sold in the same location, called comps. In this process, we start out by taking a look at the comps and make adjustments to the known sold price to equalize as much as possible with the subject property.
For instance, if we are trying to estimate a value for a 3-bed, 2-bath home by using a 3-bed, 3-bath comp, then we’d need to start with the price for which our 3/3 comp sold and adjust it down for the fact that our subject only has 2 bathrooms whereas the comp has 3. And this type of arbitrage of specs and features would need to be completed at a rather detailed level in order to arrive at a reasonably refined estimate of value.
Further, having completed 100 of these, we’d begin to see the big picture, which would suggest that in this particular marketplace, and with this age range and style of home, people are willing to pay $X for a second bathroom, $Y for a third bathroom, $Z for a third bedroom, etc. Additionally, we’d begin to see that typical per-square-foot pricing of a single level 3/2 home is $A, and it needs to be discounted by $D with each additional bedroom, etc.
This is somewhat of a science and a bit of an art. But, the thing to note here is the following: When we discuss pricing in this context, what we’re really talking about is how much people — meaning willing and able buyers — are willing to pay for this, that, or the other feature. Yes, we use the CMA to estimate the value of a specific house, but let’s not forget that what we are really tracking is market behavior.
Having put this into context, let’s come back to the cap rate.
What Is the Cap Rate?
The thinking in multifamily goes like this:
People buy multifamily because of the income (this is not actually completely true, but for now let’s just generalize). Therefore, while the CMA looked at property features to establish marketplace value, in multifamily we look at income and/or income potential.
The question our analysis asks is this: How much are people paying for this type of asset, with this much income potential, in this location?
Now, suppose you analyzed 100 closed transactions. Suppose you had accurate data as to the sale prices, incomes, and expenses for all 100 of these. With this data, you could figure out the NOI for each one and later back into the cap rate that the buyers paid, right?
Well, suppose all 100 of these closed transactions fell in the range of 7–7.5 percent cap rate. That gives you a pretty good idea of the market appetite, doesn’t it? I mean, they are not paying 4 percent cap, so they are not super aggressive — but neither are they holding out for 10 percent cap. From this data, you certainly glean a lot relative to market behavior.
A Question to Consider
Suppose you are analyzing this data in order to support your decision-making relative to a potential acquisition on your desk. Pardon my French, but what the hell did this data tell you that’s particularly useful relative to underwriting the worth of an investment? Did you find out how much or how stable your cash flow is likely to be in the years you are planning to hold? Did you find out what your expected appreciation might be? Did you find out how much the cash flows represented by this asset are really worth in the future (net present value of these cash flows)?
Don’t misunderstand me, cap rate is an important metric, just not the way most people use it.
What About Cash-on-Cash?
Suppose you work at BiggerPockets, which, aside for one or two people, means that you are like twelve years old. Well, when you are young like that, you get hungry a lot. Do you see yourself leaving the building, getting on your bicycle, and riding over to the closest sandwich shop to pick up a big-old sub, large enough to feed everyone in the office? I see it — do you see it?
The sub has everything on it. There’s the beef, the cheese, and even some kosher pork (that only happens when you’re twelve and working at BP, but there you go).
You hop back onto your bike and ride back to work as quick as you can, ’cause you are hungry. You find a cutting board, lay the sub down, and begin to cut.
You offer a slice to Mindy first, naturally. You’d offer the first slice to Josh, but he’s not there. And in his absence, Mindy is the boss, so you do the right thing. Her slice is awesome. Moist, with lot’s of mayo, cheese, beef, and ham. Just perfect. Mindy is happy!
You grab a slice for yourself, and whoops — no cheese. It still tastes pretty good, but somehow, you didn’t get any cheese. And the slice is light on the mayo. Mindy’s return is 100 percent. Your’s, just three inches away, is only 83 percent. Yep, that cheese and mayo is worth 17 percent return. And you ain’t got any.
Static Metrics Stink
Cash-on-cash return is what we deem a static metric. It is akin to a snapshot in time. A still image. It is a true metric for that specific fragment of time, but this fragment may or may not be indicative of the entire tapestry that is your sandwich (I mean, your investment). Just because something is true over here, doesn’t mean it’ll be true over there.
Wouldn’t it be better to collect data from all of your coworkers, see how everyone’s slice of sandwich tasted, and then evaluate the entire sandwich is a whole? Cash-on-cash doesn’t do that.
Most of what needs to be said on this subject is indeed in this article. However, most of it is between the lines. I’ve got to have some fun too.
What do you think?
Do you agree that cap rate and cash-on-cash aren’t super useful in these scenarios? Share your opinions below!