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4 reasons why cap rates are misleading

Last week, I promised to write about cap rates in the context of valuation.

A lot can be said about this topic, but if there’s one thing you learn today let it be this: **most people rely on cap rates too much **when evaluating LP investment memos.

4 reasons why cap rates are misleading:

• length of lease

• creditworthiness of tenant

• diversification of lease stream

• in place vs market rent

First, some background:

Capitalization rate (or "cap rate") = Net Operating Income (or NOI) / Purchase Price.

There are some variations on this such as Unlevered Yield on Cost, which I will write on in the future.

Let’s dive in:

1) length of lease

You see "11% cap" on LoopNet and get excited.

What's wrong?

Cap rates aren't created equal and you realize that there's only a year left on the lease.

In other words, this 11% cap rate isn't comparable with an 11% cap rate with 10 years remaining on the lease, since there's lease up (finding a suitable tenant) and TI (funding dollars into the building to attract a tenant - acronym for Tenant Improvements) risk within the next year.

Since it’s unclear when you’ll find a tenant, carrying costs upon vacancy need to be vetted deeply (property taxes, insurance, and other costs that the landlord has to continue paying despite having no income)

2) creditworthiness of tenant

You see a "12%" cap listing, and it even has a 15 year lease.. have you struck gold?

Chances are, the company who'll be paying you rent is in distress and has a high chance of defaulting on the lease (at which point you’ll need to shell out legal dollars to go after them.. and might fail)

In other words, a 12% cap with an investment grade tenant is very different from 12% cap leased to small firm

This concept applies to multifamily as well - a building might be 95% occupied, but only 50% of the leases are current on payment (i.e. the “creditworthiness” of tenant base is weak). I have seen this personally and will write more on this later.

In other words, leases aren’t created equal

3) diversification of lease stream

You see two deals listed:

• 8% cap deal with two tenants and

• 8% cap with one tenant

All else equal (and there are a lot of assumptions here), you'd always prefer the former, since your income stream is diversified.

Some variables to consider here are:

• Credit strength of the tenant (keeping rents constant, one would prefer one lease with a very strong tenant over two weak tenants)

• Visibility into the future income stream and likelihood of renewal (e.g. how the tenant’s business is performing at any given time from financials - a lease with a financials requirement or a sales requirement is much better than no reporting whatsoever)

4) in place vs market rent

This is probably the most famous

You see a 4% cap multifamily deal and say "seller (or GP in our case) is an idiot... a 4% cap?! PASS!"

While you're eating ice cream, someone else models out the rent roll and realizes that the in place rents are 50% below market

In other words: Even though the property was listed for 4%, the near term (~1 year) "stabilized" cap rate is closer to 8%.

Once stabilized you can continue owning & refinance, or sell (assuming exit cap rates are well below 8%, you’d do extremely well)

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