The Truth About Cap Rate: 5 Myths—Busted
A lot of what you read about cap rate is simply wrong. I'm here to dispel the myths and tell you the real story.
Perhaps no topic is more overrated, misunderstood, or debated than cap rate. I would also argue that cap rate has more inaccurate or misinformed articles written about it than pretty much any other topic on real estate, but no one wants to listen to me argue.
Instead, why not just forget everything you’ve read about it, and start from scratch here?
Cap Rate Definition
Cap rate is short for “capitalization rate,” which is a mathematical formula used by appraisers to measure the value of income-producing real estate. Because it’s impractical to compare one income-producing property to another the same way you can with tract homes, a different method was needed to gauge value. Cap rate became the most widely accepted measurement.
Cap rate is calculated by dividing the net operating income (NOI) by the property’s purchase price (or sale price, depending on which side of the table you are sitting on).
For example, if the property produces $100,000 of NOI and is purchased for $1 million, the cap rate is 10%. If the purchase price is $2 million, the cap rate is 5%.
NOI is income minus operating expenses. Debt service payments and capital improvement costs are ignored for the purpose of this calculation.
NOI / (Purchase Price) = Cap Rate
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$100,000 / $1,000,000 = 10% Cap Rate
Commercial real estate investors have an odd love affair with cap rate, which leads to all sorts of opinions on what cap rate is and what it means for their investment strategy. Here’s a list of some common statements I hear and read about cap rate:
- “Cap rate is equivalent to the return I receive if I pay cash for the property.”
- “I need to buy at a high cap rate to get the returns I’m looking for.”
- “A high cap rate means I’m getting a better deal.”
- “If interest rates rise by 1%, cap rates have to increase by 1%, too.”
- “I bought the property at a 5% cap rate and turned it into a 10% cap rate!”
What do these five statements about cap rate have in common?
They are all wrong. Yes, every one of them.
Myth Busted: The All-Cash Return
I wish people would stop saying, “Cap rate is the return you get if you paid all cash.” It is not.
Here are two ways that this is wrong:
I once bought a property that was around 300 units. The previous owner had their eye completely off the ball and hadn’t kept their rental rates up with the market. The day we closed escrow, our new management team arrived at the office to take over. Each time a new prospect walked in the door, we raised the quoted rent $25. We did this all day until the first person said no.
It took five prospects, so we immediately had a $125 increase in new leases on the first day. It would only be a matter of time before the entire property cycled to the higher rate.
Did that affect our return? You bet it did. So much for cap rate telling us anything about our expected return.
Even if we hadn't done that, to buy the property, we would have needed to inject additional cash to close the purchase. Closing costs, title insurance, legal fees, immediate capital improvements to correct deferred maintenance—you name it. The price we paid was not the cash we would spend.
Cap rate is net operating income divided by purchase price. Our purchase price was less than the cash outlay, so this misconception of cap rate fails for a second time.
Myth Busted: Higher Cap Rates Mean Higher Returns
Reflecting on our second incorrect statement about cap rate, “I need to buy at a high cap rate to get the returns I’m looking for,” consider these two examples:
Example 1: An 8% cap rate on a stabilized property in a stagnant market with no rent growth, no job growth, a slowly declining population, and no ability to push rents with renovations.
Example 2: A 6% cap rate in a market with above-average population growth, job growth, and income growth with stable occupancy and high rent growth. The property is underperforming relative to nearby comps. With some minor cosmetic improvements, rents can be increased 20% on each unit that is rented to a new resident in upgraded condition.
In nearly every case, over the long-term, example 2 will outperform example 1 despite example 1’s higher cap rate.
Myth Busted: High Cap Rates Mean a Good Deal
“A high cap rate means I’m getting a better deal.” This statement by itself is false.
Our examples above illustrate this point across two different markets, but even within the same market you could have a property selling at an 8% cap rate that could be a worse deal than another property in the same market selling at a 6 percent cap rate.
Example 1: An 8% cap rate on a 50-year-old property in which all the interiors have been recently renovated and the seller has pushed the rents to $25 higher than the comps. The property doesn’t need a thing; it is totally turnkey.
Example 2: A 6% cap rate on a 20-year-old property that hasn’t been touched since it was built, except that the owner just put on a new roof. Interiors are original, rents are $150 below market, and renovated comps are getting $100 more than the non-renovated comps.
Example 2 is more likely to be a better deal despite the lower cap rate. There’s nothing you can do to push the income in example 1; it’s been pushed as far as it can go. And example 1 is 50 years old. So despite the upgrades, the maintenance bills are likely to increase substantially over time. There could also be big-ticket items in your future, such as a new roof, foundation repairs, new windows, and new heating and cooling systems. The list goes on and on.
But in example 2, you have multiple opportunities to increase income. The low-hanging fruit is just bringing the rents to market rate, in line with non-renovated comps. Then you have the option to go to the next level by performing minor interior cosmetic improvements to push rents further toward the level of the renovated comps in the area.
Myth Busted: Rising Interest Rates Mean Rising Cap Rates
It is often thought that cap rates move when interest rates move. You might hear people say things like, “If interest rates rise by 1%, cap rates have to increase by 1%, too.” There are two concepts at play that give people reason to believe this.
The thinking is that if someone can invest in risk-free treasury bonds at 3% interest, why would they invest in real estate at a 4.5% cap rate? There isn’t enough of a risk premium to justify investing in real estate at such a low yield.
Hopefully by now you already see why this argument is a red herring. Cap rate is not a measurement of investment return; it is a measurement of market sentiment. Under the right conditions, it’s entirely possible to capture a 20% return from a 4% cap rate property. As a result, comparing risk-free yields to real estate cap rates is like comparing airplanes to submarines.
The thinking here is that if interest rates rise, it costs more to borrow money. Therefore, you have to buy at a correspondingly higher cap rate in order to preserve investment returns. There are two reasons why this usually isn’t true.
First, the debt represents only a portion of the purchase price, such as 65-75%—and in many cases even less—and the remainder of the purchase price is cash. This mutes the effect of a higher interest rate on the borrowed money to some extent.
Second, if interest rates are increasing, it is also likely that the economy has momentum and perhaps inflation. Rents tend to rise during inflationary times, which in turn increases the income from the property—perhaps to an even greater extent than the increased borrowing cost takes from it.
The bottom line is that cap rates compress and decompress at the whim of market sentiment. When real estate becomes less popular, prices go down, which means cap rates go up. When real estate is highly sought after, prices go up, which means cap rates go down.
Cap rates can also move when outside factors alter investment returns. For example, if rent growth slows or operating expenses go up, the only way to achieve the same desired investment return is to pay a lower price for the property, which means buying at a higher cap rate. Interest rates are only one of the many inputs in solving for returns. Higher borrowing costs will certainly have an effect, but interest rates and cap rates don’t move precisely in parallel.
Myth Busted: Forcing the Cap Rate
Here’s another funny statement I hear often: “I bought the property at a 5 cap and took it to a 10 cap!”
Someone might be inclined to boast this claim if, for example, they bought a property that historically threw off $100,000 NOI for $2 million (a 5% cap rate) and then they were subsequently able to increase the NOI to $200,000. But this claim fails from two directions.
First is that cap rate is simply a measure of market sentiment, so “taking a 5 cap and making it a 10 cap” means that they just destroyed the market and lowered their property’s value by 50%. Remember, cap rate isn’t about their property; it’s what the market is willing to pay for an income stream.
They alone can’t move the whole market, so they alone can’t move the cap rate. No matter what they did to the income later, they still bought $100,000 of historical NOI for $2 million, and that will always be a 5% cap rate.
The second reason this statement fails is that they undoubtedly had to invest capital into the property by making physical improvements to drive the revenue higher. Boasting about moving cap rate (which is calculated using only the purchase price) ignores the additional capital required to achieve the higher NOI. And of course, this says nothing of the fact that using post-acquisition NOI to calculate cap rate is bending the rules of the formula itself.
What anyone making this claim should be talking about is their yield on cost. This is similar to cap rate but more like a first cousin than a twin. To calculate it, divide the current NOI by the entire project cost, including purchase price, closing costs, sponsor fees, and capital improvements.
Using the property from the example above, let’s say that $1 million was spent on closing costs, fees, and improvements, bringing the total project cost to $3 million, and the NOI grew from $100,000 to $200,000. In this case, they could claim that they bought the property at a 5 cap and after they stabilized it, they brought the yield on cost to 6.7%.
This doesn’t sound as sexy as claiming they “made it a 10 cap,” but at least they’d be telling an accurate story.
And here’s one more thing: It is entirely possible to double a property’s income and add no value at all. In the above example, if $2 million was spent on closing costs, fees, and improvements, the total project cost would be $4 million. Doubling the NOI to $200,000 results in a 5% yield on cost. If the market cap rate is still 5%, the property is worth exactly what was spent on it—there was no value added. Even if someone claims that they “brought the 5 cap to a 10 cap”—they really did nothing at all.
What other myths have you heard about cap rate?
Add them in the comments below!