Warning: Cap Rates Range From Unhelpful to Downright Deceitful. Use These Metrics Instead.

by | BiggerPockets.com

It’s shocking how even experienced multifamily investors refer to the cap rate as the end-all, be-all end-all metric. But in all actuality, it is nothing more than a measure of value at a moment in time.

Taken in isolation, it can range from deceitful to unhelpful.

When you are looking at the cap rate, you are seeing a stabilized property’s natural rate of return for a single year, without considering the debt on that property.

Now, is most commercial real estate bought with cash—or is it purchased with a healthy dose of financing?

Since my multifamily deals are done with financing, I find a metric meaningless when it doesn’t take into account the returns after debt-service.

So why would anyone tout the glories of a high cap rate?

A Higher Cap Rate Means Higher Returns, But…

Yes, investors prefer higher returns.

But typically, higher cap rate properties are lower quality properties. So in that sense, cap rate is a measure of risk in the deal. And you’ll want to understand risk-adjusted returns to compare potential investments across different markets.

In a market like the U.S. Midwest, liquidity and economic prospects are comparatively low, so investors may need to see high returns right off the bat.

But other markets offer the chance for value appreciation in the future.

Think of coastal U.S. cities or massive hubs like Hong Kong and London. They have global investors fighting to buy the limited amount of assets that exist in those areas. As a result, they are highly liquid investment markets. The demand places upward pressure on prices and leads to low cap rates.


Related: 5 of Your Most Burning Questions About Cap Rate, NOI & More—Answered

These markets also tend to have strong economic growth factors. This makes it possible for owners to increase rents, relative to market, with weaker fundamentals.

Picture an asset with obvious mismanagement or deferred maintenance. The rents and the cap rate are not where they should be—an opportunity.

Value-Add Multifamily Deals Expect Lower Cap Rates

Going back to our original definition, the cap rate applies to stabilized properties. But putting together a value-add deal means looking for multifamily properties that have not hit a stabilized level. It’s why they are interesting in the first place.

As investors, we are looking to increase the cap rate after purchase. This is because we will increase value through forced appreciation. OK, then, does that mean the cap rate is actually important, but that you should just be looking for currently under-valued rates?

Not so fast.

Now, it might be easy to become obsessed with the exit cap rate (a.k.a. terminal value). You get into a deal that estimates a much higher exit rate than acquisition rate because you are buying a slick value-add property.

But the future buyers don’t care that you bought an asset at “below market” rates. At exit, the asset will still be priced at its prevailing market rate, then paid accordingly.

And since we’re considering all this at the start of the deal, you are working with a projection. Nothing more.

So the real point is that there are more important metrics to consider.

(Nearly) All Metrics Can Be Gamed

Now, the usual boilerplate says that I should declare the actual metric that should be deified instead of the cap rate. But I can’t do that. No one can.

When scribbling notes for this article, I wanted to tie it all up nicely so it would “feel right.”

But that would be horsesh*t. The real takeaway is that feelings don’t matter and that no metric is king in isolation.

Still, we must act on available deals, so I’ll leave you with a brief consideration of some impactful metrics—along with their specific blind spots.


IRR/Equity Multiple

In place of cap rate, the savvy investor jumps to IRR (internal rate of return) or equity multiple. The theory goes that the higher the exit cap, the lower the IRR/equity multiple metrics.

IRR can be vastly interesting, and that is where it is risky.

There are a lot of moving parts: purchase price, exit price, rent growth, debt terms, etc.

Related: Sorry, But Cap Rates and Cash-on-Cash Are Worthless When Evaluating Multifamily

So the expanse gives cover for a seller or syndicator to game the numbers. At worst, it can mean someone more or less saying, “Oh, you don’t like the IRR? Well, give me a second… there, how about now?”

I personally look to the equity multiple as a pure measure of wealth.

It says, plainly, that for every dollar you put in, you get a dollar plus X back. No discounting. No fancy math. There is some clarity when starting with the equity multiple.

However, the simplicity of that metric means it does not account for time. To explain, I will have a lot of takers if I say 10x dollars after one year. Not so much after 10 years.

Discount Cash Flow (DCF)

The measure of value across time is best left to another article, but it is usually represented by the discount cash flow (DCF) analysis.

DCF is the gold standard—and least used—measure of valuing commercial real estate.

So, at the risk of tying up a complicated topic too neatly, I would say that once you start ignoring the cap rate, you can start focusing on the equity multiple and then work your way through the DCF calculations.

If it wasn’t a bit of a grind, do you really think it would be such a sound investment stream?

Simplistic cap rate analysis is alluring, yes. But as you demand real results, start looking for the more meaningful metrics.

What metrics do you prefer—and why?

Weigh in with a comment!

About Author

Omar Khan

Omar is a multifamily syndicator targeting 100+ unit B/C apartment complexes in TX and FL. Omar’s company has a $200M track record over the past 3 years with an emphasis on capital preservation in addition to income and growth. As a CFA charterholder, Omar upholds the highest standards of ethics and integrity while continuing to advise high net-worth individuals/companies in multifamily investing through his company, Boardwalk Wealth. Contact Info.: Website: Boardwalk Wealth Email: [email protected]


    • Michael P. Lindekugel

      in hot markets such as Seattle 1031 tax deferred exchanges generally only enrich the brokers pushing based on the deals i have analyzed. the statutory timelines can put the exchanger at a negotiating disadvantage. if the exchanger is paying a premium for second leg acquisition and its more than 15%, then there is no point to the exchange with capital gain tax treatment rate of 15%. tax deferred exchanges are deferral not an abatement of the final tax due.

  1. Michael P. Lindekugel

    more to the point, the reason capitalization rate is a poor indicator of ROI is because it has nothing to do with ROI. Its an index only applicable when compared to other data points in the study. It measure an assets ability to generate Net Operating Income NOI compared to its price or value. or, the terms in the capitalization rate formula can be moved around to calculate any of the missing terms. Capitalization rate is similar to a Price to Earning P/E ratio. Investors don’t rely P/E alone. There is full scrutiny and financial diligence of financial statements and discounted cash flow analysis of IRR, NPV, and MIRR, etc. those DCF metrics are applicable to real property.

    all ROI calculations are based on cash flows CF. There are few accounting and tax treatment items to account for from NOI to calculate CF. one of the most often missed is cost recovery or depreciation which shields Net Income of taxation increasing the cash flow. Properties with a high concentration of value in the land will have little cost recovery. a property with a high capitalization and little cost recovery will have a low IRR. That can create a false positive Go decision to invest. In Seattle, this mistake is common. We have older buildings.

  2. Cody L.

    I’ve told this to everyone who will listen. In class C land, buying based on “CAP rate” will put you out of business. It’s based on NOI which is based on income/expense which is based on whatever the owner experienced (or felt like putting in). Their p/l != your PL. There are at least 10 ways to fudge NOI, thus cap, to make it say whatever you want.

    • Omar Khan

      Finally! You are preaching to the choir, brother. At the Class C (and sometimes B) level, the P&L is rarely ever presented according to proper accounting principles i.e. owner decides what goes in and how it is presented.

      Making generalized statements based on such P&L can lead to bad decisions and heartburn.

  3. Darrell D.

    Good article. I’ve been in the market for properties and I’ve been very disappointed to find that almost all properties are priced for a 10% Cap. When digging deeper, I could find on many occasions the numbers where far off. I could find single family homes with 20-30% cap rates but I did not have the opportunity of leveraging my investments and long term growth was not good.

    Anyway, what is DCF? Is this a secret calculation or is this leading to a new pro-perk at BP?

    • Omar Khan

      Thanks Darrell.

      DCF = discounted cash flow . It is the gold standard valuation method used to estimate the value of an investment based on its future cash flows. It is not secret calculation and is widely used by practitioners all over the world.

  4. Garrett White

    Well put Omar! Love internalizing your philosophy on underwriting from articles/podcasts.

    With regards to the IRR, like you mentioned, there are many ways Syndicators can tweak numbers to make the IRR appealing. One of the most common I’ve found is the exit cap rate. You stated that value add cap rates are typically lower, so, with that said, what is a conservative way to project exit cap rates?

    For example, if an investor buys a Class C deal at a 5.5 cap because there’s a value play, would you consider it conservative to exit at a 6-6.5 cap (based off the 10 basis points per year expansion rule)? This just seems a little aggressive if stabilized Class C deals have historically traded at an average of 7.5-8 caps, but the argument I hear is that you can’t base it off historicals? This is something that I’ve really been contemplating – I’m really interested to hear your opinion.

    Thanks man, and keep up the solid work!

    • Omar Khan

      With the big caveat being that estimating exit cap rates is a complete cr*pshoot and no one having a crystal ball, I would suggest looking at the exit cap rate as a combination of:

      – Holding period
      – Type of debt (e.g. 10-year agency vs. 3-year bridge)
      – Market and sub-market economic growth estimate
      – Operator experience.

      Some math geeks can point to using Monte Carlo simulations but is a fancy way of saying that you’re going to use a lot of math to come up with the same solution (with no guarantee of a better estimate).

      In other words, this is not entirely a mathematical exercise. Depending on the asset/market/operator, I have seen exit cap rates being anywhere from 50-200 bps.

      My suggestion is for investors to look at the NOI first to ascertain if that is conservatively estimated. After that, each investor should input their own #s with regards to exit valuation because everyone has a different opinion. You are not optimizing to find the perfect NOI rather you are doing this exercise to determine if your #s are within a reasonable range of the operators.

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