What is a Cap Rate… Truly?

Don’t let the cap rate fool you, the future cash flows are far more important.

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

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