Do CAP rates really matter? The truth about CAP rates.
[{"id": "g2g60ng", "text": "This guy has no idea what he is talking about.", "replies": [{"id": "g2gae8u", "text": "I didn\u2019t watch, but why is he in his car?", "replies": [{"id": "g2gcegj", "text": "Because he's just sooo busy driving around cutting deals he can't sit in a office to record like a regular person or he's homeless, not sure which.", "replies": [], "depth": 3}], "depth": 2}, {"id": "g2gagdx", "text": "What part do you specifically disagree with or think he's wrong? \n\nMy view is that a cap rate is more of a sizing tool metric than anything else. Tells you nothing about the situation of a property and doesn't factor cost of capital (equity and debt).\n\nYou cannot look at cap rate on its own to determine the value of an asset.", "replies": [{"id": "g2i0oat", "text": "Cap rates measure what investors have paid for NOI.  In a 10% cap rate market they paid $10 for each possible dollar of NOI.  In a 5% cap rate market they paid $20.  It is a valuation metric.  It does not measure \"return\".", "replies": [], "depth": 3}], "depth": 2}, {"id": "g2hvpoo", "text": "then why did you post it? lol", "replies": [{"id": "g2i1qn6", "text": "To expose the scammer?", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g2g8qip", "text": "Cap rates are just the inverse of a multiple... bro.", "replies": [{"id": "g2h4rtp", "text": "I\u2019m not sure if you\u2019re referring to the price to equity multiple or equity multiple. Yes to the former, no to the later", "replies": [{"id": "g2hdnlp", "text": "Purchase price for a stabilized asset can be expressed as a multiple of Year 1 NOI. The inverse of that multiple is the cap rate. For example, a purchase price of 20x Year 1 NOI is the same thing as a 5.0% cap rate.\n\nI was trying to be a bit tongue in cheek with the tone of my reply, but I guess it didn't land.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g2gemd2", "text": "Not sure that\u2019s a very clear argument. At one point he mentions to buy at a 1 and sell at an 8. I mean that\u2019s the opposite of a cap rate where lower is better from a buy/sell perspective. \n\nI think the confusion is that most people don\u2019t take the time to understand exactly what a cap rate represents. Sure it\u2019s not a perfect measure but it\u2019s not meant to be. It\u2019s a quick short hand for some basic financial metrics.", "replies": [{"id": "g335yfx", "text": "Wait, wut? Enter at a 1 and exit at an 8? Maybe he meant to say buying at a 1 on existing income (virtually zero) then upping the income (leasing mostly) and exiting? It sounds so awkward that way though!", "replies": [], "depth": 2}, {"id": "g33ejxl", "text": "He\u2019s saying you buy distress which doesn\u2019t value on a cap so you\u2019d pay a 1% cap, then you get cash flow up to where you are making an 8%, you\u2019d sell at a market cap, let\u2019s say 5% but your cash flow is up so you make a large profit.", "replies": [{"id": "g33gjyu", "text": "This doesn\u2019t make any sense. Why would you buy any distressed deal at a 1% cap?  And even still selling at an 8% is going the wrong way. A higher cap rate is only better for the buyer not the seller. In my industry stabilized mid-market deals transact are around a 7-8% cap. Trophy assets in CBD maybe around 4-6% depending on specifics. Only the junk deals trade anywhere in the 9+ range either because they are crap real estate or there are major problems with huge capital infusions required for whatever reason. \n\nPoint being any discussion to justify a buy low cap and sell high cap proves there is a misunderstanding of what cap rates are actually representing.", "replies": [{"id": "g33gubu", "text": "If you buy a deal at 60% occupancy you typically are looking at future value, the existing cash flow may be 1% since it\u2019s distressed. You stabilize and all of a sudden you are cash flowing 8% per year on your purchase price. You list the asset and and sell on your cash flow at a 5% cap, you have created a tremendous amount of value. What\u2019s confusing about this?", "replies": [{"id": "g33iuwl", "text": "I\u2019d actually be curious to see a hypothetical NOI and sales price metrics based on your scenario for purchase and sale where those numbers show a 1% cap rate at purchase and a 8% cap rate at exit.", "replies": [{"id": "g33jjw5", "text": "Ok. Let\u2019s say a deal has 100 units and rents for $1000/mo. It\u2019s currently completely vacant and the seller decides he wants to sell to you. 0% cap rate no matter what right? Let\u2019s say 50% expense ratio so when stabilized your NOI will be 100x1000x12/50 right? 600k. So what\u2019s the value? If you buy it at 3m since it\u2019s vacant (30k/unit, not income approach but comp approach), and you lease it up, now you have a 20% cash flow on your purchase price even though you bought a 0% cap rate. Market is a 5% so you take your 600k and cap it at a 5, sell for 12m. You probably put some money in to fix it up, carry the expenses before cash flow, whatever, end of the day you make a lot of money and you bought a 0 cap, it made you a 20% cap, you sold for 5%.", "replies": [{"id": "g33k3p2", "text": "Let me make it simple as it\u2019s hard to follow. Give me the following and cut out the narrative:\n\n1. NOI of property at purchase. \n2. purchase price\n3. NOI of property at sale\n4. Sales price.", "replies": [{"id": "g33k9q9", "text": "Please tell me your experience in real estate investing, I\u2019m dying to know. I\u2019ll indulge you. $0, 3m, $600k, 12m", "replies": [{"id": "g33l63d", "text": "Ok so I\u2019m going to use $1 NOI just to not break my calculator. By your metrics:\n\nCap rate at purchase: .000033%\nCap rate at sale 5%. \n\nOk I\u2019ll give you the points here in this scenario your number works. Certainly an edge case but yes theoretically you have a solid case for selling at a higher cap. I\u2019d argue that despite this being true it\u2019s not a really good example for the usefulness of cap rates. \n\nAs to my experience I typically stay in the development management world but get involved with proforma analysis from time to time.  Mostly new builds so I\u2019m not normally spending time valuing existing cash flow.", "replies": [{"id": "g33lssn", "text": "Distressed assets are a different animal on valuations, the goal is to buy distress and stabilize which changes the way the math works. A vacant building isn\u2019t worth zero because you\u2019re not using a cap rate to determine value. The cash flow you get once you stabilize is YOUR cap rate on what YOU paid but what you sell for is completely different. Anyway, I think that\u2019s what this guy was talking about. He doesn\u2019t describe it well but all of this is worth what you paid for it. By the way this happens all the time so not an edge case. Most people want to buy for a 5%, find some edge to start cash flowing 7% on their price, and sell for a 5% cap, what\u2019s important is the delta between what your cash flow % is and what cap you can sell for. Just like development, you want to build to a 6.5% return on cost and sell at a 5% cap, it\u2019s the spread that creates value.", "replies": [{"id": "g33n4bm", "text": "I suppose the value of this discussion is to underline that the main value of cap rates as a useful comparison for stabilized assets. Once you get into these massively distressed deals with major value add the purchase Cap Rate is not really a pertinent metric.", "replies": [{"id": "g33nb55", "text": "Correct! Cap rates are pretty meaningless anyway, they just compare perceived risk for stable assets.", "replies": [{"id": "gdhn5kl", "text": "Risk of what?  Class A Office CBD in Philly is selling at about a 7% cap rate.  In SF Class A Office CBD is selling at 4% cap rate.  Do you believe that the Philly risk is almost double?", "replies": [{"id": "ge3lis8", "text": "That is what the market buyer would be indicating if someone is willing to pay a 4 in SF vs a 7 in Philly.", "replies": [{"id": "ge3lvjq", "text": "Or it could have absolutely nothing to do with risk but profitability!  That Philly property could have higher capex expenses because of the climate.  Or it could be higher capex expenses because it takes 4 times as much SF to get the same NOI as SF because rents are 4 times higher per sf.  See, it may not measure risk at all.", "replies": [{"id": "ge9yh53", "text": "Ok, we fundamentally disagree but that\u2019s all good. I would encourage you to dig a little deeper on the subject but we are all entitled to our opinions, I don\u2019t understand your argument but that doesn\u2019t mean it\u2019s not valid. Any investor looks at how much they make on their investment per year relative to risk, treasuries, bonds, stocks, commercial real estate, hedge funds, private equity, it all boils down to how much return you make on your money. The obvious comparison is yield per year, you can get nothing in a bank account and have no risk, you can invest in some oil &amp; gas startup and hope you make 300%, it\u2019s all risk/reward. There is a portfolio allocation factor, meaning, diversification into different asset classes is logical and not just putting all your eggs in the safest or riskiest assets. But, in my opinion, when comparing same asset class projects, the annual return is directly reflective of the risk perceived. If I\u2019m willing to take a 4% return, I better be able to bet on it every year. If I take an 8% return on a tertiary project it\u2019s because either rents are volatile or liquidity is uncertain so I may not be able to sell it, etc, the overall risk of the project is higher and therefore I demand a higher yield. Cap rates have nothing to do with underlying capital expenditures as those are perceived to be improving the balance sheet and is not a cash flow item.", "replies": [{"id": "gead781", "text": "Your problem is that you think cap rates measure a \"return\".  But cap rates come from an income approach to VALUE called direct capitalization.  V=i/r \nIn a 10% cap rate market investors have paid $10 for each possible dollar of NOI and in a 5% cap rate market they have paid $20.  See, all it does is value NOI.  You cannot tell which market is more profitable by the cap rate.", "replies": [{"id": "gebtlvh", "text": "Ok bud, whatever you say. Have you ever actually bought an incoming producing piece of real estate? If I pay $1m for a project, no debt, and that building generates 100k, that\u2019s a 10% cap rate. If I pay $1m and it generates $50k, that\u2019s a 5% cap rate. If I gave you nothing other information besides here are two recently purchased, marketed, apartment projects, one generates 5% and one generates 10%, you would have to assume that the 5% is perceived by the market to be less risky and therefore investors would take less return on their $1m. Now I\u2019m starting to think you\u2019re trolling so I think this is going to be my last response to this.", "replies": [{"id": "gec7i3w", "text": "I am assuming that by \"generating\" you mean the NOI.  Well cap rates value NOI.  If you paid $1m for $100K NOI then that means you paid $10 for a dollar of NOI.  The other property that had a NOI of $50,000 and you still paid $1m then you paid $20 for a dollar of NOI.  See, cap rates th come from an income approach to value called direct capitalization and tells you what the market has paid for NOI.  If you haven't heard of direct capitalization then you are the one that hasn't purchased an income producing property and are the troll.\n\nUse your thought process.  If a cap rate was a \"return\" then the 10% seller has a higher return yet he is selling it for only $10.  And the low 5% cap rate guy which according to you is half the \"return\" of the other property yet he is commanding and getting $20 for each dollar of NOI.  Twice the price for half the \"return\".  I believe you live in trollville and can't answer the simple question of why half the \"return\" is sold for twice the price.  Hmmmm.....", "replies": [{"id": "geejwx0", "text": "Very simple, half the return sold for twice the price is because that stream of cash flow is considered less risky. Let me try this a different way. If you are trying to determine a valuation of your apartment complex and you have the T12 and you also have a deal that sold next door recently and you have the T12 of that asset. Let\u2019s say the deal next to you sold for $1m and T12 NOI was $100k, the buyer of that complex paid a 10% cap rate. Your asset has a T12 of $200k. What is the value of your deal? Well you would assume that if it\u2019s a similar deal in a similar location then someone would value your deal at a 10% cap rate and therefore your deal would be worth $2m. Cap rates are a way to compare deals. They also happen to be derived using the NET OPERATING INCOME which is a RETURN on your price. If I called it yield on cost maybe that would make you happy but they are the same number with the addition of closing costs. Let\u2019s run out our scenario. Deal next door just sold for a 10% cap rate, you estimate value based on that NOI and list your deal on the market for $2m. Someone comes in and offers you $4m. You have no idea why, but they offer it and buy your project. They paid a 5% cap. Why would they do that? A number of reasons could be the answer but it is very logical to assume they perceived the risk to be lower on your asset which is why they paid double relative to the comp. Maybe they think your deal is under managed or needs rehab, whatever, but the scenario we are discussing is assuming the deals are apples to apples, stabilized operating real estate in which case they perceived to be lower risk for whatever reason. The value people are willing to pay divided by the going in annual NOI is the cap rate and if someone is willing to take a lower return that means they think it\u2019s less risk. Risk and reward always go hand in hand. If you want to buy a deal right now in Austin, you\u2019ll pay a 4% cap or lower to be competitive. If you buy a deal in some random small Texas town you\u2019ll likely pay a 5.5% or 6% cap rate for the same quality deal because Austin is perceived to have higher growth potential and a safer rental pool which increases competition and drives down rates. You\u2019ve taken too much of my free time, I\u2019m sure if we talked in person we would come to an understanding but online isn\u2019t the way, I wish you luck! You actually never said if you bought income producing real estate so I\u2019d still like to know.", "replies": [{"id": "geemgg4", "text": "OK, you got it that if the cap rate comps sold for a 10% cap rate then the similar property will sell at a 10% cap rate,  If the property has twice the NOI then it will still sell at the SAME cap rate but it is the VALUE that is changed because cap rates VALUE NOI.  100% correct.\n\nLook, here's the deal.  No intelligent investor will come into a 10% cap rate market and buy at a 5% cap rate!  Why would they?  They are going to have to recoup the $2,000,000 that they over paid before they see one cent of \"return\".  Their goal would be to buy the property at close to market at close to market cap rate and then INCREASE the NOI so that then the VALUE will increase based on the market cap rate.  In your example the investor bought a $2,000,000 for $4,000,000.  That makes no sense anywhere.\n\nAnd yes i have been purchasing investment properties for over 40 years and am retired on my real estate income.  I am also recognized as an expert witness on valuations in CA.  How about you?", "replies": [{"id": "gef649b", "text": "I was in multifamily brokerage for a 15 years, probably saw 600+ transactions during that time, then bought 5,000 units of my own multifamily assets, and now raise capital in the multifamily space, safe to say we both know what we\u2019re talking about. Most people cannot raise the NOI of a stabilized asset enough to move the needle, the rise in prices over the last 20 years in multifamily has been cap rate compression, someone buys at a stable 6 and sells at a 5, happens all the time and is still happening now, even with the same NOI you have increased the value of the asset just though market perception. I will argue that the market perception of multifamily has gotten much more favorable which has caused institutional capital to flow into our space and reduce cap rates across the board. This is from the market seeing booms and busts and all the while their multifamily portfolios have stayed relatively consistent compared to retail/office/hospitality, just like what is happening right now during COVID. In addition, debt has also largely driven value appreciation but that\u2019s for a different conversation. So, institutions have now come around to multifamily being a preferred asset class which is perceived as less risky than other asset classes and thus commanding lower cap rates. I used the 10% and 5% cap rate to illustrate an example, not as a real world scenario. Again, I can get .1% at a bank, 1.5% on a treasury, 4% on a bond, 8% in the stock market, etc, as the risk goes up, so does the return. It\u2019s the same in our scenario, lower cap rate, lower risk, higher cap rate, higher risk, its just math and I don\u2019t understand which part of that you are arguing against. Do you agree that multifamily cap rates rise and fall aligned with the BBB corporate bonds? They do, because multifamily cap rates are just another way for investors to get a risk adjusted return in their portfolio. Higher risk will always mean higher rates of return.", "replies": [], "depth": 22}], "depth": 21}], "depth": 20}], "depth": 19}], "depth": 18}], "depth": 17}], "depth": 16}], "depth": 15}], "depth": 14}], "depth": 13}], "depth": 12}, {"id": "gdhnpj2", "text": "There isn't a purchase cap rate though that would have any meaning.  You would still be valuing using market cap rate from stabilized comparables  and making below the line adjustments to get market value.  True that is not all that accurate but it makes a big difference if the NOI when stabilized can be sole at a 5% cap or a 10% cap.", "replies": [], "depth": 12}], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g2gfd5p", "text": "For non stabilized, just use proforma to calculate the cap rate, not the actual NOI. No one says \u201cI bought it at a 1% cap because it was mostly vacant.\u201d", "replies": [{"id": "g2hs6ok", "text": "Haha exactly.  If someone said a deal is a 1% cap on our acquisitions call they would get laughed out of the zoom meeting.  \"Stabilizes at about a 6%\" is a very common phrase though.", "replies": [{"id": "g2hsj59", "text": "Where are you finding 6s? We have a tough time getting 5.5", "replies": [{"id": "g2huqk3", "text": "Secondary/tertiary markets.  Plus the deals usually have some hair on them which is why they need to stabilize.  Realistically they probably stabilize below a six but 6 investment committee doesn't like sub 6 deals outside of our target markets.", "replies": [{"id": "g2i4rek", "text": "Gotcha. What markets and check size? I do bridge lending and have had a lot of success on hairy deals", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "g2ggxpq", "text": "I'd like to sell him some buildings.", "replies": [], "depth": 1}, {"id": "g2gjrpd", "text": "This guy isn\u2019t so far off but I don\u2019t like his approach. First, he says you can only apply to \u201ccore\u201d which does not mean stabilized so that\u2019s off. Second, cap rates typically involve purchase price which without closing costs is not your true cost and therefore can\u2019t be your return on capital, need to quote yield on cost for that. Also, he fails to mention that cap rates are your unleveraged return on purchase price and most use debt. Cap rates, at their core, are best for comparing sales to what you are valuing as a check on price. If deal A sold a few months ago for 1m and had a 50k t3 income on t12 expenses adjusted for taxes, and it\u2019s the same profile as your building, you can reasonably assume the market price for your deal is the t3 income with t12 expenses adjusted for taxes / a 5% cap rate. That\u2019s all it\u2019s relevant for. It\u2019s comparing perceived risk of an asset. If apartments average 5% cap rates and office average 6%, office has a higher perceived risk and therefore you can pay \u201clower\u201d prices for the same cash flow. Hope this helps.", "replies": [{"id": "g2gkkkq", "text": "Also, people tend to put edit: \u201cCERTAIN\u201d expenses \u201cbelow the line\u201d so it doesn\u2019t affect NOI (since that would negatively affect pricing) so NOI does not always represent actual cash flow. Check bank statements and balance sheet as part of DD and do not simply rely on NOI as if that\u2019s what cash you\u2019ll generate, you will be disappointed.", "replies": [{"id": "g2gps1m", "text": "If someone gave me an NOI that didn\u2019t include expenses, I would instantly walk away. That deal would be a guaranteed headache", "replies": [{"id": "g2h2l1x", "text": "Philosophical question: is an NOI without expenses even an NOI?", "replies": [{"id": "g2h71ls", "text": "Its a sales pitch", "replies": [], "depth": 5}, {"id": "g2hooo6", "text": "NOI without expenses is a rent roll.", "replies": [{"id": "g2i3hlp", "text": "LOL", "replies": [], "depth": 6}], "depth": 5}], "depth": 4}, {"id": "g2ia9h4", "text": "I meant certain expenses get put below the line which inflates NOI, happens all the time, it\u2019s an accounting game. I\u2019ve bought, sold, and brokered assets for 15 years.", "replies": [], "depth": 4}], "depth": 3}, {"id": "g2hmgwz", "text": "Do you mean capital expenses or operating expenses, or both?", "replies": [{"id": "g2i1any", "text": "Capital expenses are not operating expenses so they are not part of the direct capitalization process.", "replies": [], "depth": 4}, {"id": "g2i1gyw", "text": "You\u2019re proforma needs to include both.\n\nAnd DCF is the best way to value a property\n\nCap Rate is simply the perpetually annuity formula. It doesn\u2019t find a rate of return for you. For that you need an IRR and a YOC, you can introduce leverage to play with your IRR and YOC, until you hit a return that works for your risk tolerance.", "replies": [], "depth": 4}, {"id": "g2i9vej", "text": "I mean capital expenses but people get creative on what they \u201ccapitalize\u201d below the line. It\u2019s still cash out every year and people pretend it doesn\u2019t count since is a capital item. If you are planning on cash flow from a cap rate you will miss the mark.", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}, {"id": "g335twu", "text": "That's what bugged me- your yield will depend on the financing (among other things)", "replies": [], "depth": 2}], "depth": 1}, {"id": "g2h4k5l", "text": "Yes and no, cap rate is both the expected, unleveled yield, without growth, today, and a measure of the markets expectations of that yield. So, the value is on exit. If you\u2019re developing or doing value-add, you should know the exit cap after completing and stabilizing the project", "replies": [], "depth": 1}, {"id": "g2h5fhp", "text": "Banks don\u2019t finance 1% caps. And if they did, you wouldn\u2019t resell at an 8% cap.... that\u2019s the opposite of a good investment.", "replies": [{"id": "g2i13x0", "text": " Go in at a 1% cap?  $100,000 NOI/1% = $10,000,000 value.  Double the income (NOI) to $200,000 and end up at an 8 cap  V=i/r  $2,500,000=$200,000/8%   Greg, you just lost me $7,500,000!!!!  After ALL that hard work to double my NOI.  I can't stay a multimillionaire at that rate.  We need to discuss this!   LOL", "replies": [], "depth": 2}], "depth": 1}, {"id": "g2ici18", "text": "He\u2019s in a minivan with sunglasses on his head . . .", "replies": [], "depth": 1}]