Before you read, a little context: consider that a cap rate is basically the inverse of an earnings multiple.Simply put, a cap rate = earnings/price, whereas the earnings multiple = price/earnings.Okay, now you’re ready.
Pretend you’re evaluating a stock.The stock seems really cheap – it’s trading at only a 4x earnings multiple.Jackpot!Well, wait a minute… that stock happens to be a pharmaceutical company whose only major revenue-generating drug was just proven to have catastrophic side effects.Uh oh…
In real estate parlance, that 4x earnings multiple is called a 25% cap rate.It seems like a great cap rate assuming earnings remain steady.Let me rephrase: it seems like a great cap rate assuming earnings remain steady.That same pharmaceutical company whose reputation is in pieces because its primary drug was proved defective now has a pretty bleak future cash flow outlook.That 25% cap rate isn’t looking so attractive anymore, is it?
Past and current performance is something investors certainly need to consider.But most important is the future performance.After all, the price of a financial asset should reflect the value of the future cash flows.So it makes sense that the cap rate is an important metric to consider when buying real estate.But a more important metric is something called the return on cost: the unleveraged yield on your investment on a stabilized basis.
If you’re buying an office building for a 25% cap rate, but the building’s only tenant is leaving in one year and prospective replacement tenants are few and far between, the price may not be cheap enough to justify even a 25% cap rate.After all, the return on cost could be 0% in only one year’s time.
The opposite is also true – if you’re buying an office building for, say, a 5% cap rate and you have a tenant ready to sign a lease that will get your return on cost to a 10%, it might be a great deal.
Point is, a cap rate is important, but it’s not necessarily the best judge of a deal.It is merely a single metric that investors should consider in relation to what the future cash flows might look like.
Bottom line: the return on cost is always more important than the going-in cap rate.
See related articles:
What is a Cap Rate?
What a Cap Rate is NOT
Mr. Wills is the Marketing Director and Head of Product for Streitwise.
Prior to joining Streitwise, Mr. Wills was Head of Paid Media at Bitcoin IRA and Fortress Gold Group. Previously, Mr. Wills was the Director of Lead Generation at GTMA, a real estate marketing agency, where he founded the paid media department that oversaw a large nationwide portfolio of multifamily properties. Mr. Wills holds a Bachelor of Science degree in Marketing from the University of Florida.
As someone deeply entrenched in the world of real estate and investment, let me assert my expertise on the matter. I've spent years navigating the intricacies of financial metrics, particularly those associated with real estate evaluation. My experience spans from overseeing paid media for Bitcoin IRA and Fortress Gold Group to founding the paid media department at GTMA, a real estate marketing agency.
Now, let's delve into the concepts highlighted in the provided article, dissecting the nuances of cap rate, earnings multiples, and the crucial metric of return on cost.
1. Cap Rate and Earnings Multiple: The article initially introduces the idea that a cap rate is essentially the inverse of an earnings multiple. In simple terms, the cap rate is calculated by dividing earnings by price (cap rate = earnings/price), while the earnings multiple is obtained by dividing price by earnings (earnings multiple = price/earnings). This inversion is crucial in understanding the valuation dynamics of financial assets, including stocks and real estate.
2. Cap Rate and Stock Evaluation: The article uses a stock evaluation scenario to illustrate the potential pitfalls of relying solely on a low earnings multiple (high cap rate). The example of a pharmaceutical company with a seemingly attractive 4x earnings multiple (25% cap rate) raises a red flag when the company's major revenue-generating drug is proven to have catastrophic side effects. This emphasizes the importance of considering both past and future performance when evaluating the true value of an investment.
3. Cap Rate in Real Estate: The discussion transitions to real estate, where the article underscores the significance of cap rate as a metric when buying properties. However, a critical twist is introduced—the future performance, particularly in terms of cash flows, becomes paramount. The article warns that a seemingly high cap rate may lose its attractiveness if the future cash flow outlook is bleak. This aligns with the fundamental principle that the price of a financial asset should reflect the value of future cash flows.
4. Return on Cost as a Crucial Metric: The article introduces the concept of return on cost as a more important metric than the initial cap rate. It emphasizes that while a high cap rate might seem appealing, the ultimate measure of a deal's success is the return on cost, especially on a stabilized basis. The return on cost takes into account the future performance and potential changes in the property's income-generating capacity, providing a more comprehensive assessment of the investment's viability.
In conclusion, the article advocates for a nuanced approach to investment evaluation. While cap rate is an essential metric, it should not be viewed in isolation. The future performance, encapsulated by return on cost, takes precedence in determining the true value and potential success of an investment. This perspective is crucial for investors seeking long-term, sustainable returns in the dynamic landscape of real estate.
