The Biggest Cap Rate Misconception On The Planet! Part 1 of 3

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What Space Has Been Charted

As you may know, I’ve written a lot about cap rates.  Permit me to summarize the key points.

In addition, I’ve written some published articles on cap rates such as A Guide to Cap Rate Dynamics and Cap Rate Follies.

Don’t worry – I don’t give pop quizzes.  Everyone gets a star regardless of whether they do their homework.  It’s the adult version of “no child left behind”.  If you don’t quiz me, I won’t quiz you… deal?

Here’s The Problem

Over the years, Eileen and I have spoken to many buyers and sellers about cap rates.  Other than investors who know how to calculate cash-on-cash returns and some review appraisers and players on Wall Street, there is a huge misconception out there.  It’s so deeply ingrained and so common that all the others accept it at face value.  It even applies to many commercial real estate brokers, which surprised me when we round tabled this discussion.

Are you ready?  Band leader, may I have a drum roll please?  The misconception is this – the cap rate is the return on investment!  So when you see a property for sale at a 10 percent cap rate, you’re getting 2 percent more return on investment than if you buy the same property at an 8 percent cap rate, right?  As John McClain said in Die Hard, “Sorry Hans, wrong guess. Would you like to go for the double Jeopardy where the scores can really change?”

What’s Wrong With This Myth?

There are a couple of big problems with this myth.

  • A cap rate represents a return of and a return on investment.
  • The cap rate is the return on investment.

The Return Of Investment Fallacy

Let’s explore the first big problem.  Appraisal text and definitions of cap rates on the internet cite the return of investment being a part of the cap rate. I have to admit, though, that I’ve never seen the return of investment portion quantified anywhere.  I conjure up mental pictures of the old mortgage amortization tables that show how much principal you are paying on your loan as well as the interest on any payment into the future.  Another idea is that the nebulous “appreciation” factor is handled by the return of investment (it’s also possible that it could be part of return on investment or split between return on and return of investment).  Yet another theory is that by added the “appreciation” factor into direct cap rates, it puts it on par with discounted cash flow so the two can be used as checks and balances.  Still.. how in the world could a cap rate that represents a snapshot of an investment sold on a particular day embody a return of investment?

Perhaps the implication is that the purchaser will pay down the mortgage over time (i.e. loan amortization), thereby returning more of the investment debt free to the buyer.  Here’s a quote that discusses this.

Capitalization rates are an indirect measure of how fast an investment will pay for itself.  In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%).

In theory, this sounds good.  But let me ask you this – when was the last time you saw a commercial property loan without a balloon?  So how much of the investment is returned prior to the balloon coming due considering that the balloon typically occurs at the point where only 15 to 50 percent of the loan has been amortized?

OK, reality aside, let me pose the question to you another way.  Where in the equation of a cap rate (net operating income divided by value) does it address mortgage amortization or even anything future oriented?  It doesn’t.  The only workaround I could see is if a purchaser did a discounted cash flow projection and looked at the average cap rate during the holding period.  Yes, I know… I’m deep into theory and way out of the realm of the practical but it’s the one and only exception I can think of, regardless of whether it’s realistic.

Now don’t get me wrong.  I’m not saying that a cap rate does not have a return of investment component.  I am saying two things:  I can find no way to rationalize it or measure it and I have yet to speak to a buyer or seller that can tell you anything about their return of investment that was built into the cap rate.  I’m sorry… it’s not enough to say “I bought the property and expect to have appreciation” and yet have no clue as to how that affected the cap rate at the time of sale.  There is a disconnect there.  ‘Same goes for buyers and sellers; they’re just as disconnected as I.  Perhaps the decades-old discussion of cap rates having a return of investment needs to be readdressed.

Return of investment is loan amortization to me.

Just Whetting Your Appetite

In Part 2 I will discuss another cap rate fallacy – that the difference between two cap rates is the expectation of appreciation.  In Part 3 I’ll really get into why using a cap rate as a return on investment measure is a big mistake.

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