Why CAP rate is completely meaningless…and incredibly valuable!

Why CAP rate is completely meaningless…and incredibly valuable!
Let me start off by saying that I have been in the commercial real estate business for 31 years. I have owned properties and still do. I routinely invest in commercial real estate and I have helped hundreds if not thousands or people do just the same.
There are a few things that never change…
1. If the property doesn’t cash flow when you buy it…it probably never will.

2. CAP rates, GRM’s and GIM’s are nearly meaningless when investing in commercial investment real estate…and I will tell you why.
First off, CAP rates or Direct Capitalization Rates compare and contrast the price paid for a property in a transaction with the property’s Net Operating Income (NOI). So if a property is purchased for $1,000,000 and it produces $100,000 in NOI… ($100,000 ÷ $1,000,000 = .10 or 10%). In plain common sense language the Buyer will get a 10% return on his or her investment.
The problem with the CAP rate is that is only a snap shot in time…what time? The last day of the year the property was acquired. Why? Because it compares the NOI (all the money the property generated that year) to the purchase price of the property. It cannot be used for the second year because the Buyer isn’t buying it again so there is no purchase price to compare the NOI to.
The next problem that arises is how many investor purchase a property for the last day of the year. All the investors I know buy and hold property for a period of time to enjoy the benefits of the cash flow and the cost recovery neither of which are part of the CAP rate analysis.
Speaking of time how many investors would be interested in a building offered at a 12% cap rate based on current income? What the CAP rate doesn’t consider is what happens next year when that anchor tenant leaves and the CAP rate goes to 0%…any takers? Conversely, my building is 50% vacant…but in January of next year ATT (purely hypothetical and for illustrative purposes only) move into my building for the next 50 years…what happens to the CAP rate then?
The other thing that cap rate doesn’t consider is the effect of leverage. According to statistics I read recently 90% of all commercial investment real estate purchases require some form of financing. CAP rate completely ignores the effects of financing.
Finally, CAP rate does not include taxation. Owning commercial investment real estate can have substantial benefits by allowing the owner to shelter a portion of the NOI from taxation. That “tax shelter” can be substantial and CAP rate does nothing to address those benefits.
CAP rate does have its place in the pantheon of investment measures. When acquiring a property a CAP rate should serve as a “signpost” for further exploration. If the CAP rate seem low for that particular type of property in that market the investor should ask why and explore what the reasons are. If the CAP rate seems high there may be a good reason. Usually CAP rates will reflect a “risk premium” for that property in that market.
A classic example of that gap is a Walgreens NNN leased investment which is being offered at a 5% CAP rate versus an apartment building where the rents have to be collected every Friday afternoon before 3 pm. Which may trade at a 10%, 12% or higher CAP rate.
CAP rate is also instrumental in determining a terminal sales price for an asset by Capitalizing the last years income at a Terminal CAP rate the disposition price is established for a Discounted Cash Flow Model (more about that later).
GRM (Gross Rent Multiplier) and GIM (Gross Income Multiplier) represent the two worst investment measure ever invented by mankind! In the authors opinion they should be banned from use forever!
GRM expresses the relationship between the monthly rent collected and the purchase price ($8,333 X 120 = $999,960 or roughly $1,000,000) while GIM expresses the relationship between the annual gross rent and the purchase price ($100,000 x 10 + $1,000,000). What the hell does that even mean? Who evaluates an investment property on a monthly basis? The most frequent use of these two is in the multi-family arena. One of the characteristics of a mutli-family property is short term leases. Nobody leases an apartment for years and years they will typically lease for one year of in some markets several months at a time. When the lease expires the vast majority of tenants go on a month-to-month basis. Therefore, the value of a property would vary from month to month if the Gross Rent Multiplier were used to value the asset.
The other thing is just like CAP rate both the GIM and GRM do not consider the income taxes or mortgage financing. But the real problem is that neither the GRM nor the GIM make any provisions for operating expenses. Theoretically, a property could be purchased with an attractive GRM or GIM and be losing money from day one.
Additionally, they are both short term measures and are specifically not to be used for multiple years or ownership. They do however serve a purpose, they both serve as indicators as to whether the property is performing within a reasonable range of similar properties in the market place. If the GRM or GIM seems too high or too low the investor would do some serious “forensic real estate” before making an investment.
So, in summation CAP rate, GRM, and GIM are nearly worthless as an investment measure but have value in that they allow a quick “down and dirty” comparison of the property to its cohorts. They should use only to compare and contrast other similar investment offerings and as a tool to indicate whether further investigation is needed.
For my money a far more useful and accurate analysis would be a DCF or Discounted Cash Flow model which considers time, income taxes, and the effects of leverage during the ownership period.

Adam Von Romer Senior Investment Associate at Fitzgerald Group

LinkedIn: http://www.linkedin.com/pub/adam-von-romer/2/812/152/en

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