The capitalization rate (or cap rate) is a specialized aspect of real estate investment. That’s why I posed the following question to several leading real estate investors: How strongly do you consider cap rates when evaluating deals?
Here are seven active investors’ opinions on how important capitalization rates are in real estate investing:
- Ryan Groene said “I like to treat (cap rates) like I treat my trash . . . it normally ends up in the garbage.” As a value-add manufactured housing investor, a deal with a low or even negative in-place NOI doesn’t have a cap rate that translated into other important metrics like cash-on-cash return, internal rate of return, debt, and capital required. However, he says that cap rates are more important on the sale of the property. He bases the exit cap rate on the historical cap rates for manufactured housing, which is between 8% and 10%. Overall, he cares about cap rates, but it will not stop him from investing in a deal with a 1% cap rate if the terms are great and he hits his desired returns.
- Garrett White is of a similar opinion. He doesn’t place much emphasis on in-place capitalization rates in real estate deals (i.e., the cap rate based on the current net operating income), because, depending on how much value-add is present, he can buy a property at a really low cap rate and still make it a solid deal. Cap rates mean the most to him on the exit. To determine the exit cap rate, he looks at the range of the historical cap rates rather than the 10bps per year expansion rule that is common.
- Elisa Zhang only considers the entry cap rate in order to compare it to the exit cap rate. For most of her deals, the exit rate is set to be at least 1.5% to 2% higher than the entry market cap rate of similar deals in the same submarket.
- Tyson Cross also agrees with Ryan, Garrett, and Elisa. He said that the capitalization rates in real estate is one of the most misused metrics in commercial deals and is widely thought of as the standard for measuring properties. In reality, the importance of the cap rate is varied based on the property type and location, and you should put more emphasis on the cap rate upside after executing your business plan (i.e., the exit cap rate or cap rate at refinance).
- Todd Dexenheimer also believes that the cap rate is a misused metric, but for opposite reasons. To him, cap rates have been downplayed in the current market and are very important when the market shifts to a buyers’ market. Commercial real estate is generally valued based on cap rates, so he says that not considering cap rates when evaluating deals is a mistake. With that said, he also added that you need to factor in many things when looking at a deal and that a good deal varies from investor-to-investor based on their personal goals. These important factors include cash-on-cash return, cash flow, internal rate of return, debt service coverage ratio, the overall business plan, market factors, and the likelihood of being able to achieve the projected results.
- Ash Patel also believes that cap rates are important, specifically on non-commercial real estate that is fully leased and triple net leases. If the non-commercial real estate is partially vacant, the cap rate should reflect the current occupancy. For gross leases and value-add, cap rates should be considered more of a benchmark.
- Gwyeth Smith, who admittedly is just starting out, fell somewhere in the middle. He understands capitalization rates in real estate shouldn’t be used as the only factor to qualify a deal, but it still has its uses. For example, he used the cap rate as a negotiating tool on a recent deal. However, the most important factor to him is the debt service coverage ratio, because if the deal meets Fannie Mae qualifications, it validates his underwriting to a certain extent.