In the multifamily market, the cap rate or “capitalization rate” plays a dominant role in determining the market price of a property. By definition, it is the calculation used to “determine the ability of the property to carry debt as well as for a measure of overall returns” (Miller & Geltner, 2005, p. 298). However, there are drawbacks that makes the cap rate insufficient for determining investment value. Firstly, the cap rate offers a limited perspective; it only looks at the first year forecast of cash flow; it does not take into consideration the impact of financing and taxes (CCIM Institute, 2005, p. 6.6).
These are important considerations in the overall determination of investment performance. Among investors, it is a “common misconception when using the term ‘cap rate’ that some investors assume the overall cap rate is equal to the return on their invested capital; this is rarely the case” (CCIM Institute, 2005, p. 6.6). Yet, investors continue acquiring properties at 4% – 5% cap rates. It is keeping the price of properties inflated in certain markets. An investor that buys an apartment building at a 7% cap rate could still find themselves earning very low returns–or losing value–if the property does not cash flow as anticipated. Therefore a cap rate is insufficient, because it does not include important considerations such as investor preference, capital investment, or material financial information that would impact how a property performs over the term of the anticipated holding period.
A true reflection of investment value also takes into account the total cost of the property, which includes capital investments, the cost of capital, and the impact of taxes. A cap rate does not accomplish this. It may offer a starting point as to understanding market sentiment; but in order to make an accurate determination of how much a dollar truly earns while it is invested requires that an investor focus on “IRR,” or internal rate of return, instead of focusing on the cap rate. An investor must examine the cash flows that a property produces; they should also determine the perceived risk factor of those cash flows, assign a required rate of return for the level of risk assumed, and then apply that required rate when examining the cost of acquiring, renovating, operating, and maintaining the property. Otherwise, an investor may find themselves realizing paltry returns, if any return on investment at all.
Two properties in the same market might have the same market value by cap rate, but if one property has a higher cost of operation or requires a significant investment of capital to make it rent-ready, it will increase uncertainty and, thus, increase the risk of the cash flows. This increased risk should also increase an investors’ required internal rate of return, which is “the percentage rate earned on each dollar invested for each period it is invested” (CCIM Institute, 2005, p. 6.10). In a low cap-rate environment, many sellers cling to cap rate driven trends and many of them remain firm on price regardless of circumstances surrounding the property. While this is certainly a sellers’ prerogative, a savvy apartment buyer will not let emotion drive the investment decision. Apartment buyers must know up-front how their money will perform and only choose to invest in apartment buildings that will provide attractive internal rates of return—which should be in the range of 15% – 20% for multifamily properties—give or take—depending on the level of risk perceived and assumed by the investor.
Owning and operating an apartment building carries more risk than parking money in a CD or savings account; because of this risk, it should earn a higher return on investment, “To compensate an investor for more or less risk relative to other investment opportunities requires a change in the required rate of return” (Miller & Geltner, 2005, p. 336). Assuming more risk should be a factor in investors’ perception of investment value and what they ultimately pay for the property. If not careful, apartment buyers that rationalize acquiring properties at low cap rates may find themselves earning returns comparable to “safer” investment vehicles such as CDs and savings account. Savvy apartment buyers know that when “determining investment value of a property, the investor decides what to pay to achieve given performance objectives,” (CCIM Institute, 2005, p. 6.2); the sellers’ desire for top dollar does not come into play. Basing investment decisions on a market cap rate alone is the equivalent of catering to sellers; it leaves apartment buyers at risk of finding each dollar invested underperforming—or losing value. Apartment buyers must be sufficiently compensated for the level of risk they assume, or else money is better off invested in a “safer” vehicle—not real estate.
In order to obtain a perspective that would allow an investor to make an informed decision, an investor would need to look beyond the first year using historical operating data within the context of the intended holding period (typically 5 or 10 years). A cap rate cannot do this, so a cap rate should not be used as the basis of establishing investment value. Investment value is “the amount that an investor would pay for a specific property, given that investor’s investment objectives, including target yield and tax position” (CCIM Institute, 2005, p. 6.3). Please notice that this definition of investment value does not include the involvement of seller preferences.
CCIM Institute. (2005). CI101: Financial Analysis for Commercial Investment Real Estate. Chicago: CCIM Institute.
Miller, N. G., & Geltner, D. M. (2005). Real Estate Principles for the new Economy. Ohio: South-Western.