Why To Take Care When Calculating Cap Rate
The Cap Rate being what it is, a ratio combining Net Operating Income and Value/Cost, two pretty important aspects of any property, is just as easily misused by certain parties as it is used legitimately. Following are three ways Cap Rate can be misused that you should be aware of.
1. Cap Rate With Pro Forma Numbers: Given that we as humans tend to seek pleasure while simultaneously avoiding pain, we are susceptible to overestimating the upside, and underestimating the downside. Brokers and smart sellers know this, so when we ask for information about the property they ply us with Pro Forma numbers; the “best case” scenario after all the hard work and improvements have been made, knowing we will go directly to there in our imaginations and conveniently skip over all of the annoying planning, supervising, managing, and flat out hard word involved with making it that way.
The obvious problem with this is by not focusing on the current condition of the property, all the repair work and cost cutting needed, or current income of the property, the Cap Rate is distorted, as you assume it reflects the future (higher) income of the property that isn’t yet there. This leads to you not acknowledging how little the property is worth now, and consequently not negotiating as hard and giving the Seller the beating he/she rightly deserves in order to get the price down to where it makes sense.
The upshot is you pay too much for the property, and only realize it after you have taken possession and face the mountain of hard work involved with turning the property around, all the while knowing there is only a trifling reward waiting for you at the end of it all. This only has to happen to you once before you give Pro Forma numbers the contempt they deserve when provided to you by a Broker or a Seller. It’s a standard negotiating gambit on their part, and you need to be aware of it. Accept Pro Forma numbers at your peril.
2. Inaccurate Income And Expense Figures: One of the figures used to calculate the Cap Rate is Net Operating Income. The Net Operating Income is arrived at by subtracting Operating Expenses from Gross Rents. When the expenses, or rents, are not accurate the Cap Rate is not accurate, and it gives you a flawed picture of how much return the property generates, and how much risk there is associated with owning the property.
This may happen through the Seller simply providing you with estimates of the expenses and rents. But just as often it happens due to sellers either minimizing expenses, or excluding them from the property information altogether. Brokers must by law provide accurate information to you, however they are limited by what sellers actually provide them.
It is critical for you to get accurate information up front, so you can value the property correctly and arrive at an offer price that is accurate, or determine if indeed you want to buy the property at all. The best way to get accurate rent and expense numbers on the property is to get the owner or Broker to provide you with an Income Statement for the previous month on the property.
When you have accurate figures will be able to determine an accurate Cap Rate for the property.
Things To Remember About Cap Rate:
Cap Rate does not take into account financing. It is no more than the rate of return the property produces assuming an all cash sale. Any considerations you weight regarding financing you use to buy the property take place outside the Cap Rate calculation.
A good example of this is in an article I read about an investor who formed a REIT to buy Class A apartment buildings in 2010. In the markets he was interested in his target properties were selling at a 5% Cap Rate. His cost of funds from raising money through his REIT was 3%. So with a 2% spread between the Cap Rate of the properties and the REIT’s cost of funds the only question remaining for the investor was, “how many units can we accumulate in the next 12 months?” The answer for that particular investor was 20,000, and a lot of positive cashflow was created for the REIT.
By having an “accurate” read on the rate of return provided by a particular class of property in a particular market, and the risk associated with it, the investor was able to use Cap Rate to make a solid decision and act massively on it for the short period of time the market conditions creating opportunity existed.