Man leaning on building

Investment Cap Rates: The Good, the Bad and the Ugly

My partner and I are once again marketing an investment property for sale, and once again we find ourselves embroiled in the never ending haze of the infamous cap rate.

Man leaning on building

Those who know me and have seen my past commentary surely would say I don’t like them and that I operate outside of the “commonly accepted” box by not using them for investment analysis.

Not true! Like is a relative term so I can’t speak to liking or disliking but I do understand they‘re a valuable tool when considered properly, and I do calculate and use them on a regular basis. However, what I HATE is when they are used as a definitive tool for decision making!

“It must be a _____ cap or I won’t offer on it” or “I only buy at a ____ cap”.

We are working with a group now that made an offer on one of our properties and told me up front the price was generated from “the” cap rate calculated from the information provided. When I asked what the cap was they told me without issue. Problem is, try as I may, with the numbers provided I could not come up with “the” cap rate.  When I enquired further it was immediately apparent, they were manipulating the expense numbers (mostly higher) to arrive at a cap rate. Totally their perogative to change the numbers as they see fit, but let’s all be clear that it  is “their” cap rate not “the” cap rate or “our” cap rate for that matter. I hope you can see the distinction.

Here is a perfect example; the purchaser has made on offer based on “their” cap rate of 5.25. They suggest “our” price is something below that. The two parties are less than 50,000 apart and are at loggerheads. We ask to review the numbers again. We spot a couple things right away. The snow removal number reflects one on the worst winter conditions in the past 10 years and is easily 3000 over the average for the past few years. We also can see that the taxes are 37,900 which they have rounded up to 40,000. That is a 5,100 swing that should go directly to the bottom-line. Doesn’t seem like much on total expenses well over 120,000 annually, but if you capitalize that amount at “their” cap rate of 5.25 it has a value of over 97,000, well beyond the value we are at loggerheads over.

And therein lies the problem. We are negating over decimal points on a cap rate that is inherently arbitrary rather than true value to the investor.

Look at cost base, which is a much more definitive judge of the market than a supposed market cap. Look at lease rates, location, conditions and use all to create your value. And please don’t make your ultimate decision based on a number that is so easily influenced.

I have titled the piece the Good, the Bad, and the Ugly, in my humble opinion here is how I see it.

Good:

Cute Bunny

Cap rates are a valuable tool when comparing one investment to another, and when the variables involved in calculating are understood  it can used effectively as a general guideline for valuation.

Bad:

The amount of variables involved in the calculation and the opportunity to manipulate the numbers to reflect one’s own coloured glasses.

Bad bunnyUgly:

When a number generated by a formula that is fraught with the so many components influenced by individual design and motive is used as an absolute.

 

Not long ago I created a brief video on cap rates where you will hear more detail but with a similar theme. I would encourage you to have a listen at the link below.

Cap Rates


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