{"id":103650,"date":"2018-11-09T11:00:01","date_gmt":"2018-11-09T18:00:01","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=103650"},"modified":"2021-03-16T14:51:04","modified_gmt":"2021-03-16T20:51:04","slug":"ignore-cap-rates","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/ignore-cap-rates","title":{"rendered":"Warning: Cap Rates Range From Unhelpful to Downright Deceitful. Use These Metrics Instead."},"content":{"rendered":"

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.<\/span><\/p>\n

Taken in isolation, it can range from deceitful to unhelpful.<\/span><\/p>\n

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.<\/span><\/p>\n

Now, is most commercial real estate bought with cash\u2014or is it purchased with a healthy dose of financing?<\/span><\/p>\n

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.<\/span><\/p>\n

So why would anyone tout the glories of a high cap rate?<\/span><\/p>\n

A Higher Cap Rate Means Higher Returns, But…<\/h2>\n

Yes, investors prefer higher returns.<\/span><\/p>\n

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.<\/span><\/p>\n

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.<\/span><\/p>\n

But other markets offer the chance for value appreciation in the future. <\/span><\/p>\n

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.\u00a0<\/span>As a result, they are highly liquid investment markets. The demand places upward pressure on prices and leads to low cap rates.<\/span><\/p>\n

\"calculate-cash-on-cash\"
\n
\nRelated:<\/strong> 5 of Your Most Burning Questions About Cap Rate, NOI & More\u2014Answered<\/a><\/em><\/p>\n

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. <\/span><\/p>\n

Picture an asset with obvious mismanagement or deferred maintenance.\u00a0<\/span>The rents and the cap rate are not where they should be\u2014an opportunity.<\/span><\/p>\n

Value-Add Multifamily Deals Expect Lower Cap Rates<\/h2>\n

Going back to our original definition, the cap rate applies to stabilized properties.\u00a0<\/span>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.<\/span><\/p>\n

As investors, we are looking to increase the cap rate after purchase. This is because we will increase value through forced appreciation.\u00a0<\/span>OK, then, does that mean the cap rate is actually important, but that you should just be looking for currently under-valued rates?<\/span><\/p>\n

Not so fast.<\/span><\/p>\n

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.<\/span><\/p>\n

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.<\/span><\/p>\n

And since we\u2019re considering all this at the start of the deal, you are working with a projection. Nothing more.<\/span><\/p>\n

So the real point is that there are more important metrics to consider.<\/span><\/p>\n

(Nearly) All Metrics Can Be Gamed<\/h2>\n

Now, the usual boilerplate says that I should declare the <\/span>actual<\/span><\/i> metric that should be deified instead of the cap rate.\u00a0<\/span>But I can\u2019t do that. No one can.<\/span><\/p>\n

When scribbling notes for this article, I wanted to tie it all up nicely so it would \u201cfeel right.\u201d<\/span><\/p>\n

But that would be horsesh*t.\u00a0<\/span>The real takeaway is that feelings don\u2019t matter and that no metric is king in isolation.<\/span><\/p>\n

Still, we must act on available deals, so I’ll leave you with a brief consideration of some impactful metrics\u2014along with their specific blind spots.<\/span><\/p>\n

\"commercial-upgrades\"<\/p>\n

IRR\/Equity Multiple<\/h3>\n

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

IRR can be vastly interesting, and that is where it is risky.<\/span><\/p>\n

There are a lot of moving parts: purchase price, exit price, rent growth, debt terms, etc.<\/span>
\n
\nRelated:<\/strong> Sorry, But Cap Rates and Cash-on-Cash Are Worthless When Evaluating Multifamily<\/a><\/em><\/p>\n

So the expanse gives cover for a seller or syndicator to game the numbers. At worst, it can mean someone more or less saying, \u201cOh, you don\u2019t like the IRR? Well, give me a second… there, how about now?\u201d<\/span><\/p>\n

I personally look to the equity multiple as a pure measure of wealth.<\/span><\/p>\n

It says, plainly, that for every dollar you put in, you get a dollar plus X back. No discounting. No fancy math.\u00a0<\/span>There is some clarity when starting with the equity multiple.<\/span><\/p>\n

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.<\/span><\/p>\n

Discount Cash Flow (DCF)<\/h3>\n

The measure of value across time is best left to another article, but it is usually represented by the discount cash flow (DCF) analysis.<\/span><\/p>\n

DCF is the gold standard\u2014and least used\u2014measure of valuing commercial real estate.<\/span><\/p>\n

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.<\/span><\/p>\n

If it wasn\u2019t a bit of a grind, do you really think it would be such a sound investment stream?<\/span><\/p>\n

Simplistic cap rate analysis is alluring, yes.\u00a0<\/span>But as you demand real results, start looking for the more meaningful metrics.<\/span><\/p>\n

\"\"<\/a><\/p>\n

What metrics do you prefer\u2014and why?<\/em><\/p>\n

Weigh in with a comment!<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

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.<\/p>\n","protected":false},"author":241313,"featured_media":77028,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4252],"tags":[],"class_list":["post-103650","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-deal-analysis"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/103650","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/241313"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=103650"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/103650\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/77028"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=103650"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=103650"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=103650"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}