CAP rates are a widely used valuative tool in real estate investment analysis, but they can sometimes be misleading due to their simplicity and the assumptions they rely on. Here are some reasons why relying solely on CAP rates might not give a complete picture of an investment’s potential.
- Overlook financing costs: CAP rates are calculated based on the assumption of a ‘cash’ purchase, meaning they do not account for the cost of financing. The actual return on the investment can vary significantly depending on the terms of the mortgage financing used to purchase the property. For example, today an investor is able to get better financing terms for multi-family than non-multi-family investments. These better terms should lead to a stronger return. Purchasing a multi-family property that has a lower CAP rate might give an investor better returns than a non-multi-family investment with a higher CAP rate.
- Do not consider future changes: CAP rates are based on the current net operating income (NOI) of a property and do not account for potential changes in income or expenses. If a property has rental rates that are below market average, the CAP rate will not reflect these potential variables; in the Lethbridge market, most lease rates are significantly below market. An investor should underwrite with market rates and then adjust for the length of time before the lease comes up for renewal.
- Excludes capital expenditures: Major repairs and improvements (capital expenditures) are not included in the calculation of the NOI, which can make the CAP rate appear more favorable than the actual financial reality of maintaining the property over time. An investor should treat these expenses as part of the purchase price, under the assumption that they are not included in the operating costs.
- Market variability: The CAP rate does not reflect risk profiles associated with location or tenant stability. Two properties might have the same CAP rate but vastly different risk profiles due to location or the quality of the tenants. Location, location, location. If the current tenant terminates, how long will it take to lease the vacant space? An investor should allocate a vacancy rate to the NOI, depending on the location. A better location could mean a lower vacancy rate.?
- Over-simplifies comparison: While CAP rates can help compare different investment opportunities quickly, they oversimplify the comparison. Properties may have different growth prospects, lease terms, or other qualitative factors that a CAP rate calculation does not capture. For example, CAP rates do not consider the functionality of the property, which will determine how appealing the space would be to a range of users and could affect the time it takes to lease any vacancy.
- Market costs: Another consideration that CAP rates do not take into account is the relative value of the building based on what it would cost per-square-foot to build today. If it is more than - or even equivalent to - the cost of building today, it is best not to pursue that property. When current leases expire, it will be very difficult to renew at rates higher than what the current rates are.
Because of these limitations, CAP rates should not be solely relied on to valuate a property. A thorough analysis of a potential investment property also considers factors like cash flow analysis, internal rate of return (IRR), and an examination of the local real estate market conditions.
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Doug Mereska | Managing Director / Broker
Josh Marti | Principal, Senior Associate
Vinko Smiljanec | Associate
Director, Business Development
9 个月Thanks Doug, for your insights and focus on the Lethbridge market
Providing CRE market insight & solutions to industrial building owners, tenants & growing businesses in SC Wisconsin and N Illinois. Your success starts here- mcguiremears.com
10 个月Doug, this is really good. Fresh off my CCIM designation I quickly learned each investor weighs valuation in a variety of ways.