Dear Investor,
If you've ever talked with a commercial real estate sponsor, you've probably heard a lot of chatter about cap rates. By technical definition, a cap rate is the net operating income (revenues minus expenses) of a property divided by the purchase price. For those more familiar with the stock world, a cap rate is essentially the inverse of a PE ratio – a 5% cap rate would be equivalent to a paying 20 times earnings for a stock. In theory, real estate investors should be interested in buying at high cap rates and selling at low cap rates. Metrics like cap rates help investors answer the question how much am I willing to pay for the operating income provided by this asset?
In order to answer that question, here are two important follow-up questions investors should also be asking:
- How consistent and/or perpetual is the operating income going to be?
- Is there an opportunity to grow the operating income and if so, how much is it going to cost?
By way of disclosure, we have an advertising relationship with this MLG Capital, meaning we get paid for making this introduction. As always with these types of deals, consider this an introduction and not a recommendation. Every deal is unique and the responsibility to vet any and every deal you invest in still lies with you. This opportunity is available to accredited investors only (income of $200K+ or net worth of $1M+, excluding your primary residence).
All too often, investors get hyper focused on a cap rate but fail to ask the two follow up questions above. Consider a couple examples:
- An investor is considering two single tenant retail buildings. Building A is offered at a 10% cap rate (10x earnings) and Building B is offered at a 5% cap rate (20x earnings). On the face of it, the first option would be a no brainer – you're getting way more cash flow relative to your purchase price! However, if the tenant in Building A only has 2 years left on its lease and the tenant in Building B has 15 years left on its lease, then the answer isn't as clear, because it's very possible that Building A tenant leaves after it's lease and the 10% cap rate goes to 0% until the landlord can find a new tenant – which can be very expensive! By contrast, Building B is set up to enjoy many years of cash flow.
- In this scenario, asking how consistent and/or perpetual the operating income is going to be is critical in making an informed decision. Other factors that could impact the going concern of a property's cash flow could be the financial position of the tenant, the age of the property, the quality of the location, the potential for new supply/competition, etc.
- An investor is looking at acquiring a multifamily building in a well-located part of town. The Seller's asking price contemplates a 4% cap rate, which feels a little low. However, this savvy investor does some homework and realizes that the average rent at the subject property is $1,000/month, where the average rent at similar properties nearby is $1,250/month. Just by bringing the subject property up to the market, the investor could grow revenues by 25%, which could result in a stabilized cap rate of 6%, once all the leases have been brought to market. However, the investor must factor in the time it will take to turn leases and if there is a need to invest additional capital in the property to allow the property to achieve the higher rents.
- In this scenario, asking if there is an opportunity to grow the operating income and how much it will cost is critical in making an informed decision. Making reasonable assumptions about how to grow a property's operating income is perhaps the most critical part of making a real estate investment. It's imperative that the assumptions made are believable and achievable in order to execute the strategy. Other ways to grow a property's operating income might be reducing expenses or leasing up vacancy.
TL;DR - Cap rates are a very important metric, but there's more to know than just a cap rate when considering an investment opportunity. If you're interested in learning more about how MLG Capital is finding value and looking at cap rates in their deals, please feel free to reach out here.
Learn more about MLG Capital today
Jim and Brett
James M. Dahle, MD, FACEP
Founder, The White Coat Investor
Brett Stevens, MBA
COO, The White Coat Investor
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