Cap Rates Don’t Matter as Much as You’ve Been Told – Here’s Why

Cap rates are one of the first metrics newer investors look at when analyzing a real estate deal, since these are easy to calculate and easy to understand.

But even though these can be helpful to get a general sense of pricing, cap rates don’t give you anywhere close to a complete view of an investment, and in some cases, these can even end up being somewhat misleading.

So in this post, we’ll break down why cap rates might not matter as much as you might think, and what to focus on instead when evaluating a commercial real estate deal.

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Problem #1: Cap Rates Are Easily Manipulated

The first reason why cap rates can be misleading is that these can be very easily manipulated to push pricing on a deal.

The cap rate is calculated by taking the going-in net operating income (NOI) of a property and dividing that by the value of the property. This means that the higher the NOI is in comparison to the asking price, the higher the cap rate is ultimately going to be.

Since buyers that are focused on cap rates typically want to see these as high as possible when investing in a property, both brokers and sellers are heavily incentivized to maximize that going-in NOI in any way possible.

And in a lot of cases, this means that a property’s advertised going-in cap rate will be calculated based on a trailing 3 months (or even trailing 1 month) annualized NOI figure, which very often reflects a best-case scenario.

This means that sellers might do things like postpone necessary repairs and maintenance to decrease expenses, offer aggressive leasing incentives to drive up occupancy or in-place rents, or even temporarily increase things like late fees or application fees.

On retail, office, and industrial properties, brokers will also sometimes add future leasing assumptions related to space that’s planned to be delivered vacant when the property is sold, assuming market or even above-market rental rates (even though those lease terms aren’t guaranteed to materialize).

The key point here is that brokers have a lot of flexibility in how they present NOI figures to potential property buyers, and they’re incentivized to use the most aggressive assumptions possible to maximize pricing. Because of this, you’ll always want to run your own NOI calculations to come up with a number that you feel accurately represents the income you could generate.

Problem #2: Cap Rates Ignore Debt and Capital Expenses

The second reason why cap rates don’t tell the full story is that they don’t factor in debt financing or projected capital expenses, both of which can have huge impacts on the performance of an investment.

The cap rate only looks at the relationship between the net operating income and the purchase price of a property, which will obviously affect the economics of a deal, but the amount of debt used and the terms of a loan can have material impacts on investor cash flows.

For example, a property marketed for $10 million at a 6% cap rate would be projected to generate $600,000 in NOI for the investor in the first year of ownership, which is a 6% yield on an all-cash investment.

However, if that same property is financed with a loan using a 65% LTV ratio, a 5% interest rate, and interest-only payments in the first year of the loan term, that same property would produce a significantly higher going-in yield of 7.9% after factoring in debt.

And on the capital expense side of things, if that same property has some deferred maintenance and needs $250,000 of work done in the first year of ownership, that investor’s yield will go back down to less than 1% after taking this into consideration.

The key takeaway here is that capital costs and financing terms can make or break a deal in many cases, and just looking at the cap rate when analyzing a potential investment ignores some of the biggest performance drivers when investing in commercial real estate.

Problem #3: Cap Rates Don’t Equal Equity Returns

This leads directly into the final point I want to make in this post, which is by far the most important, and this is that cap rates don’t tell you anything about projected equity returns on an investment.

While a cap rate can be helpful to get a general sense of pricing, investors get involved with real estate to earn a return on their capital, and those returns are measured using very different metrics.

In this industry, investors will typically look most closely at the IRR, the equity multiple, and the cash-on-cash return, all of which can vary significantly regardless of the cap rate.

In fact, properties with the highest amount of upside when it comes to NOI growth will often be priced at the lowest cap rates, and properties with the least amount of NOI upside will be priced with the highest cap rates. And this means that a 5% cap rate deal might end up being a significantly more attractive investment than an 8% cap rate deal, even if that going-in yield isn’t initially as strong.

A Tale of Two Properties

To see how this might play out in practice, let’s look at a sample property acquisition in a slow-growing market. In this area, demand is weak and developers can easily build new product, and the property is priced at $5 million at an 8% cap rate.

Let’s also say that, due to declining population growth over the last few years, lenders see this as a risky market to enter. Because of this, they’re only willing to issue loan proceeds of up to 55% of the purchase price at a 6% interest rate, amortizing over 25 years. And as equity investors, we’re only assuming to see 2% annual NOI growth over the next 5 years.

Let’s also say that there’s a lot of deferred maintenance at the property, which will require an estimated $175,000 per year in costs in the first 2 years of ownership, which are assumed to be funded by cash flow the investor would generate during this time.

Taking all of these things into consideration, if at the end of that 5-year period we assume to sell the property at that same 8% cap rate that we bought it at, we’d generate an 11.1% IRR, a 1.7x equity multiple, and a 5.9% average cash-on-cash return.

However, let’s look at an example in a quickly growing market where demand is strong. In this area, there are major supply constraints, and the property is priced at $25 million at a (much lower) 5% cap rate.

Due to the growing population in the area, lenders also see this as a relatively safe market to enter, and they’re willing to issue loan proceeds of up to 65% of the purchase price. The loan is priced at a 5% interest rate with full-term interest-only payments, and we assume we’ll see 4% NOI growth over the next 5 years.

This property is also newer and doesn’t have any outstanding capital needs If at the end of this 5-year period, and we’ll assume to sell the property at the same 5% cap rate that we bought it at. And in this case, we’d generate a 15.2% IRR, a 1.9x equity multiple, and a 6.2% cash-on-cash return, all of which are higher than the deal with the (significantly) higher cap rate.

Focus on What Actually Matters

The IRR, equity multiple, and cash-on-cash tend to be much more heavily scrutinized in commercial real estate, and there’s a lot of work that goes into creating the cash flow projections used to calculate these metrics.

And if you want to learn more about how to build out a financial model to analyze commercial real estate investment opportunities beyond just looking at a cap rate, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.