Cap Rates Can Be Risky?

Thomas Winfield-Real Estate Broker

Multifamily Specialist
CalBRE # 01926518
562 264 5935
Thomas-Winfield@KWCommercial.com

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The Capitalization Rate (Cap Rate) is the most widely used metrics by investors. It
calculates a rate of return for a property if it is purchased all cash. This is a metric
that should be compared to the corresponding market cap rate.
The cap rate is computed by dividing the NOI (Income) by the Value (asking Price).
This will give a rate of return for the investment.
Other metrics can be calculated using the cap rate equation. For example, the
property value can be computed by dividing the income by the cap rate. From this
calculation, it can be shown that the higher the cap rate, the lower the price/value
of the property and likewise, the lower the cap rate, the higher the price/value of
the property.
The NOI for the property can be computed by multiplying the cap rate by the
price/value.
Cap rate is also a measure of risk. Because the cap rate is a measure of return, the
higher the cap rate, the greater the perceived risk to the income.
Two methods of determining the amount of risk are by: 1) comparison to a risk-
free investment and 2) comparing to the market cap rate.

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The least risky investment is the 10-year U. S. Treasury Note. This investment is
guaranteed by the U. S. Government. Historically, the cap rate for a real estate
investment has been roughly 3.5 percentage points above the treasury rate. The
difference between the cap rate in the treasury rate is considered the risk
premium, or the amount you are paid for taking the risk of purchasing real estate.
If a property does not provide the ability to reach or exceed the spread between
the treasury rate and the property’s cap rate, then you may want to consider
other investments.

Another view of cap rates is the comparison to the property Class. The table
above shows the historical cap rate ranges by property class.

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 Property Cap Rate vs. Market Cap Rate

While the historical cap rate and the risk fee rate are useful, the most important
comparison of a properties cap rate is how it compares to the cap rate of the
market/location in which the property exist.
Each market has a cap rate. It is important to find out what that rate is before
making and offer. Once we know the market cap rate, we can begin to construct
the ranges of risk. There is a moderate risk area that is just above and just below
the market cap rate. The risk in this area fits what is reflected by the market. This
means that the vacancy rates and expense rates for the property is similar to that
of the market.
If the property’s cap rate is above the moderate range, then the property’s
characteristics are not reflective of the market. It is likely to have higher vacancy
and expense rates, as well as other problems. If this property is purchased, there
must be a robust plan to bring the property’s characteristics in range of the overall
market (reposition/stabilize).
If the cap rate is below the moderate range, then the property’s features will
exceed that of the market. These would typically be Class A or B properties, or
properties with the features of a Class A or B. These properties are generally

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purchased as a store of value or tax purpose, rather than high returns. Because
they are the most expensive properties in the market, they will take a long time to
sell.

Which Property has the Best Cap Rate?

In our example in the table, each property is offered for $500,000. They are in 3
different markets. The market median cap rates and the NOI for each property is
listed.
Generally, you would like to buy the property with the highest cap rate. This
implies the highest return on your investment. In this case, property C has the
highest cap rate. However, there are other issues to be addressed here. The Pro
Forma Cap Rate is the rate based on the stabilized property’s NOI. This provides a
view of what the returns would be once the issues with the property has been
addressed.
Investors usually want to buy a property at the highest cap rate and sell at the
lowest cap rate. Property C has the highest cap rate at time of purchase. If we
consider buying property based on what we can sell it for, once stabilized, then we
would purchase property A. However, when we compare the properties to the
median market cap rate, all the properties are lower than the market cap rate, this
implies that the price of these properties are in the top half of the market prices.
If we use the market cap rate to calculate price, then, we see that property B is
the worst value (farther away from the $500K offering) and property A is the best
value (closest to the $500K offering). Another way to look at this is that property A
is closest to the market cap rate at time of purchase (5.9% vs. 5.0%) than the
others.

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One of most effective use of cap rates is the Band of Investment approach. This
allows and investor to derive a cap rate based on his/her desired return.
Sophisticated investors usually have in mind a return they want on their
investment. This is generally stated as a cash-on-cash return, which accounts for
the financing of the property. We need a method to relate a cap rate to our
desired return. The Band of Investment method does that.
This method has two components: a financing portion and an equity portion. The
calculation is based on a mortgage constant, that is use as a multiplier for the
percent of the price financed, and a desired return used as a multiplier for the
percent down payment. These two factors are added together to obtain the cap
rate that should be used to compute the value of your offer.

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In the example above, we calculate a cap rate that can be used to determine an
offer for the property that will generate the desired return.
We desire a 5% return on our investment. We put 25% down on the $500,000
investment, with a loan rate of 5%. We calculate the loan constant that will be
used to determine the loan component of the cap rate.
Since we put 25% down and wish to have a 5% return, we multiply the two factors
to compute the equity portion of the cap rate.
Based on the calculations above, we determine that we need a 6% cap rate in
order to provide us with a 5% return on our investment.
We compute our offer price based on BOI cap rate. Based on the calculations, only
property C will deliver a 5% return if we pay the asking price.

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 Summary
The proper use of cap rates can lead to better investment decisions.
When using cap rate as a measure of risk, rather than return, we can focus on
developing better offers. These offers will account for the funding and activities
necessary to reposition the property to be in line with the market in which the
property exist.
For properties with low cap rates, we must ensure they are Class A or B+ and
require no real repositioning. These properties should be bought as a store of
value with the goal of holding it for a relatively long time.
By using the Band of Investment method, we can make offers that will generate
the desired returns on our investment.