A cap rate, or net operating income divided by the sale price, is often perceived as the most important metric to investors when evaluating a property. The truth is that cap rates, especially in a marketing package, are often unreliable for determining the potential value or what someone would be willing to pay for an asset.
Below are three reasons why cap rates can be misleading, and things to consider when evaluating the validity of the cap rate.
The Current Cap Rate Is Not Always Relevant
A cap rate is used as a quick “hurdle” in investment criteria to determine whether the rest of the analysis is worth considering, and to give a good idea of how the property is currently operating. For some investors, if the current cap rate in the offering is below a certain marker the deal is no longer considered.
This can be an issue when considering non-core properties. Value-add and opportunistic investments often have operational problems that contribute to low current returns. Without underwriting the property with their own numbers and assumptions, investors can lose sight of what their own projected NOI might be, and fail to underwrite deals with a considerable spread between the going-in and potential exit cap rate.
Of course, underwriting every deal the old-fashioned way is time prohibitive. Consider evaluating other property metrics as well as market data when deciding whether or not a property should be underwritten.
From Investor to Investor There Are Major Differences in Expenses
The trouble in deriving a cap rate comes from the difficulty in determining NOI using current income and expenses. Expenses can vary widely between firms. For soft expenses such as management, fees can be very different depending on whether management is done in-house or contracted out. The level of involvement ownership desires from a manager can also have a substantial impact on expenses.
Even hard expenses can be very different; if the current owner has not appealed their property taxes for 10 years, or if the new owner intends to get individual gas meters for each tenant, expenses can change dramatically.
Realizing the difference between the property’s current operations and the acquirer’s anticipated expenses can create opportunities that the less savvy investor might miss. At first glance a cap rate can appear one way, but when evaluating how the supporting metrics are derived it can change the entire deal.
Different Professionals Calculate NOI Differently
When I was an undergraduate one of the first things we had to do in our introductory Real Estate class was to commit the NOI equation to memory with reserves below the line. I was surprised when I started working as an analyst in multifamily brokerage and the standard was to put reserves above the line, where they factored into NOI and lowered the current cap rate in the marketing package. In offerings from other brokerage firms I have seen everything from debt expense as part of NOI to only hard costs (i.e. taxes, insurance, utilities) included in the NOI calculation. These differences can cause radical changes to the actual cap rate and the income potential of the deal.
When looking for deals, I suggest looking at more than a cap rate. There is more nuance to a property than its line items.