Why are cap rates a bad metric?
Asking the question for the group. I’ve heard people say this. What is people’s issue with cap rates as a metric of value or returns?
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Cap rate is an unlevered metric- its calculation is independent of capital structure/financing. Real estate investment employs leverage so using cap rates as a measure of returns will not paint you the whole picture. Better to use cash-on-cash when evaluating levered returns in a particular year or IRR over a period of multiple years. Cap rate is more useful when metrics for comparing property values apples to apples.
The issue with cap rates is that the context and nuance of any spot "valuation" is imbedded in the NOI (consistency, risk, growth prospects - all relating to cash flows).
Applying a "market cap rate" means nothing if we don't know how you underwrote and arrived at your net operating income.
Because they're too high.
When cap rates are sub 4 they're a fantastic metric.
This is such a great cheeky comment and perfectly describes sales broker MO perfectly.
To answer OP's question, the main reason in my mind is that it assumes that asset is fully stabilized to market and has been fully squeezed of any upside which very few assets actually are.
It's important to think about using a cap rate valuation as basically the real estate equivalent of the Gordon Growth model (which you can derive with pretty simple Calc2 Math). If you do try to derive it, you will quickly see that one of the main assumptions is that the cash flows and growth rate are constant. The cap rate is basically just the R-g factor or in other words it is typically your Discount Rate/Target Rate of Return minus your assumed rental growth rate.
R-g also assumes an exit cap rate that is the same as the going in cap rate, or that valuation will grow at the same rate as NOI.
Please correct me if I’m wrong, but a cap rate is actually equivalent to the multiples method, not the gordon growth method. Cap rate is basically an inverse PE, so basically a 5% cap is a 20x multiple.
Future growth and discount rate is embedded within that multiple, but its not equivalent to a gordon growth perpetuity, right?
Cap rates just reflect a snapshot in time. If a property has major leasing upside or downside, or if there are significant planned capital/leasing costs, repositioning, etc., a going-in cap rate is going to be imprecise and won't tell the full picture. It also doesn't take leverage into account. In my opinion they are more relevant for relativity homogenous or less complex property types like a single-tenant net leased building, or a multifamily property that is fully stabilized at market rent.
Yeah imagine you have a 100% leased building with the tenant vacating in year 2 - No one would cap the first year NOI
Yeah you need to do a DCF for that to factor in lease-up timing and costs, renewal probably, etc. But on the other hand, if you have a dollar general with a newly signed 10+ year lease at market rent, a direct cap is arguably a more relevant metric in that case.
Cap rates are applied to NOI and thus do not (directly) reflect the capital intensity of different assets / asset classes
it is a "bad" metric for the same reason the P/E and EV/S were bad metrics.
It really is a bullshit metric though haha. coming from equities and seeing now how "cap rates" are used in discussion and in research, its sadly not surprising.
If sp500 (bad comparison) traded to 33x EBIT, would the same lunacy drive cap rates to 3%?
someone in inv sales isnt expected to know common valuation metrics for stocks.
I have handful of friends who can't tell you what Gross Profit or Earnings is but their in inv sales.
or actually tenant rep...
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