Cap rates and real estate investing

Cap rates and real estate investing

Beth McCandry

RANDY REID Board of Contributors

It would be hard to envisage a more misunderstood and misused tool in analyzing investment real estate than the ubiquitous cap rate. The casual use of a cap rate is not unlike the casual use of a box of matches — good for lighting a cigar, but also a barn full of hay. That is, results may vary.

Exactly what is a cap rate?

A cap rate, short for capitalization rate, is the rate of return on a real estate investment, calculated as though there is no debt. This is a simple calculation for today’s return but problematic for tomorrow’s return. Today’s return has real, historical data to derive summations. Tomorrow’s return is a more difficult prediction and risk becomes a factor. The cap rate, while forecasted with exuberant brouhaha, is often not fully realized.

Let us say one year ago an investor bought a $1 million building and is free of any debt. The investor, now landlord, leased it for $6,000 a month. The tenant paid the property taxes, property insurance and routine maintenance. The landlord was responsible for the roof, parking lot and all the HVAC repairs that exceeded $250. During the first year, the landlord paid $2,000 for repairing a small roof leak. The annual net operating income (NOI) was $70,000. That equates to a 7% cap rate. That was a real return, not a projected one.

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Vulnerabilities arise when assuming historical returns will regularly continue in the future. That may indeed happen, but certain risks ought to be accounted for. Relying heavily on cap rate projections is too simple a method to determine if an investment is any good or ought to be made. Investors’ infatuation with rates of return, without realistically considering several risks, can be their undoing.

The first risk is simple. The actual cash return is often lower than the cap rate because most properties are not fully purchased in cash. The cap rate is an assumptive rate that only exists in a specific scenario. What happens if the property described above was purchased with a $250,000 down payment and $750,000 in debt? Depending on financing terms, the mortgage payments could consume $61,910 of the $70,000 NOI. Instead of a 7% return on a $1 million cash investment, you would have a first-year return of 3.2% on a $250,000 cash down payment. Nonetheless, the investment has a 7% cap rate because it does not consider any of the indebtedness. A skimpy 3.2% return leaves little margin for error. If the tenant goes broke or skips out in the middle of the night, the investor loses his income and has a $5,000-plus monthly note payment. A 3.2% return should equate to very low risk. Indebtedness has increased the risk.

The second risk has to do with the quality of the tenant. Starbucks doesn’t skip out in the middle of the night, nor does Dollar Tree. Why would they? A tenant’s net worth and financial capability are risk factors. Financially stable companies usually behave in predictable and reliable ways. Financially unstable companies sometimes behave in unpredictable and unreliable ways.

A rate of return should always reflect the risk of the investment. Cap rates are often corralled in too tight a pen. As an example, a newly constructed building leased to Starbucks for 15 years may sell for a 4% cap rate. Should an older building with a five-year lease to a mom-and-pop operation sell for a 7.5% cap rate? They sometimes do, but should they? A thorough vetting of a tenant’s financial capabilities is a prerequisite for determining risk. A higher risk should produce a higher yield.

The third risk is projecting net income without considering future landlord repairs or increasing operating expenses. A more accurate cap rate will consider future expenses and spread those costs annually in cash reserves. When you deposit money into a reserve account, you effectively lower the net income and produce a lower cap rate. Investors rarely want to put cash flow into reserve accounts.

Let’s say that the $1 million building the investor bought has a roof good for another 15 years. The projected cost of a roof replacement is $30,000. That means $2,000 a year should go into a reserve account to pay for it. That also means the NOI is $68,000, not $70,000, and the cap rate should be 6.8%, not 7%.

Cap rates are excellent rules of thumb, but real estate investors should be wary of sloppy NOI calculations and avoid making broad assumptions about future returns without taking risk into account. Light the cigar, not the barn.

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Real estate broker Randy Reid, co-founder of Reid Peevey Commercial Real Estate, has nearly 40 years of property experience in Waco and dozens of Texas cities. He is the newest member of the Tribune-Herald Board of Contributors.