I’m raising $5.9 million on an apartment project that costs $23.6 million. I still have a ways to go to get all the equity capital raised. Among the many projects I’ve developed, this is one of the best. The project appraised at $25 million when completed. The appraiser used a 6 Cap Rate to determine the value, which is higher than most apartment projects are achieving.
While raising the equity capital, I was referred to a potential investor who had sold a restaurant building and was sitting on $1 million in cash. She was looking for a good investment. I sent her the Offering Memorandum on the project. She looked it over and responded that she wasn’t interested because her threshold is a 10 cap not a 6 cap. That got me thinking about Cap Rates and whether a 10 Cap always trumps a 6 Cap?
The “Cap Rate” stands for Capitalization Rate, a term used in real estate investing to estimate the value of an income-producing real estate investment. Real estate appraisers use “Cap Rates” to determine value. This metric is used by investors, brokers and appraisers to compare different real estate investments. It’s a “rule of thumb” to estimate value, not the “be-all, end-all” of whether or not a real estate project is a good one.
The formula for calculating the “Cap Rate” is as follows: I ÷ R = V. Some call this the “IRV” formula where “I” stands for Net Operating Income (NOI) which is the difference between the income a property achieves and the operating expenses it pays out, “R” stands for capitalization rate and “V” stands for property value. The “R” can be determined by dividing “I” by “V” (I ÷ V = R). Appraisers and brokers have access to the data of multiple property sales, which helps them establish the Cap Rate for various property types.
Since the “R” in the “IRV” formula is the denominator, the higher the “R”, the lower the value and vice-versa, the lower the “R” the higher the value. That’s why sellers want to sell at a low “R” and buyers want to purchase at a high “R.” The problem with using just the Cap Rate to determine value is that it has several inherent problems, four which are: (1) it doesn’t consider the riskiness of the investment; (2) it doesn’t consider the condition of the property; (3) a minor miscalculation in rate can cause a huge difference in value; and (4) it doesn’t consider appreciation in the value of the asset.
Cap Rates are also based on a determination of risk. Which is inherently more risky, owning a building with Walgreen’s as the tenant where the triple net (NNN) lease is guaranteed by a Fortune 500 company or owning a building leased to a local restaurant owner, where the lease is guaranteed solely by the owner of the business? Owning a Walgreen’s building is undoubtedly a safer investment than owning a restaurant building guaranteed by the owner of the business. That’s why Walgreen building sell at a 5 cap rate and locally-owned restaurants sell at a 10 cap rate. The higher the risk, the higher the cap rate.
Cap rates don’t consider the condition of the property. When purchasing commercial real estate, a term often used is “Caveat Emptor,” which means “Let the buyer beware.” The buyer alone is responsible for conducting due diligence. If something is missed, which is not covered in the purchase agreement, the buyer suffers the loss. Buildings which sell for a higher cap rate usually have issues, that’s why the seller has to mark down the price to sell the asset.
A minor decrease in the cap rate can cause a dramatic swing in value. If a property has a $100,000 NOI and a cap rate of 10, the value of the asset is $1,000,000 ($100,000 ÷ .10 = $1,000,000). If the same property has a cap rate of 8, the value of the asset is $1,250,000 ($100,000 ÷ .08 = $1,250,000). Minor changes in cap rates can cause major adjustments in value.
Finally, appreciation in value is a key component of an investor’s return on investment. If we can build this apartment project at close to a 7 cap and then sell it in five years at a 5 cap (which is what many apartments are selling at these days), the increase in value goes from $23,600,000 at completion of construction to $42,000,000, assuming a five percent increase in NOI each year. We’ve pegged the value in five years at $30,000,000, assuming a modest increase in rents and a 6 Cap rate. Some high-cap properties, like restaurants struggle with appreciation in value, which generally makes up the largest component of investment return.
In conclusion, to answer the question, “Does a 10 Cap always trump a 6 Cap?” the answer is no. It all depends on the risk of the asset class, the condition of the property, which include problems both known and unknown, the accuracy of the cap rate that’s selected, and the appreciation in value of the asset class. In my opinion, to base an investment decision solely on the initial cap rate when the property is purchased shows a lack of experience and sound judgment.