Generally, the first question we ask about a prospective deal is: “What’s the cap rate?” The reason being we want a general understanding of value. Emphasis on the word “general.” A cap rate is only one piece to a very complex puzzle. It is the unleveraged yield on a given investment (Net Operating Income / Purchase Price) – an important puzzle piece indeed! But can you solve the puzzle from just that one piece? Not even close.
A cap rate is a measure of today’s cash flow – it says nothing of the future cash flow potential. Investors must independently determine the sustainability and predictability of those cash flows. If you’re looking for a steady dividend, you’ve got to look beyond the cap rate.
A cap rate is based only on current property fundamentals – it says nothing of how those fundamentals may change over time and how they stack up relative to competitive properties. These are key indicators that should inform any investment underwriting.
A cap rate tells you nothing of the location. If it seems like a low cap rate, then perhaps the property is well-located. But then again, maybe it’s poorly-located but leased to strong credit tenants, or the tenants are on long term leases, or the property can be profitably re-positioned into a different property type altogether. Point is, you can’t necessarily surmise a property’s geographic desirability based on cap rate alone.
Clearly, there are many factors besides the cap rate that determine an investment’s attractiveness. Investors are simply unable to rely on just the cap rate. The trick is to put as many due diligence pieces together as possible in order to analyze the whole picture. A thorough analysis – beyond just the cap rate – leads to a non-investment more often than not. In fact, stREITwise probably spends just as much time analyzing deals that we end up NOT doing, simply as a result of the number of investments that don’t meet our criteria. But doing the dirty work on every deal is an important part of the investment process.