Executive Summary
A key to successful long-term investing is to ensure you’re getting compensated for the risk you’re taking on. Otherwise, the inherent risk will occasionally materialize and eat up your returns.
Investors must understand the long-term cash flows of a potential investment and compare those cash flows to the price of the asset to develop a long-term return model. This applies to stocks, real estate or any other asset class. I’ve done that analysis with stocks before, but today we’re talking about real estate.
Then the investor must determine if the projected return adequately compensates for the inherent risks as well as, in the case of real estate, the time and effort required.
With short-term treasury yields now between 4.4% to 5.4%, the hurdle rate for a real estate project is much higher than it’s been over the last fifteen years. After all, we can throw $1,000,000 into short-term government bonds and get over $50,000 per year in safe, effortless income.
Definition
Cap Rate = A property’s net operating income (NOI) divided by its asset value, which is essentially the yield of a property over one year. For example, a property worth $1 million generating $60,000 of NOI would have a cap rate of 6.0%.
A Thread
Below I share a recent thread from Twitter User @realEstateTrent that all current and potential real estate investors need to read. Enjoy!
“4 CAP this, 5 CAP that. Everyone talks about cap rates, yet most market participants have lost touch with what they mean or what they stand for. Commercial real estate is about yields. That’s it. We don’t live in these properties, and they exist as a financial product.
First, this thread refers to stabilized properties, not value-add.
Long-term leases, increases to offset inflation, no material capital updates.
It’s what most investors seek – cashflow they can depend on.
They are not looking to do a bunch of work – just collect checks.
A 4 CAP basically just refers to 4% annual return.
BUT a 4% return’s meaningless without assessing what the other options are.
If CDs pay 1%, then it makes sense to take on the added risk and headache of buying a property and not a CD.
You’re making 4x more/year, right?
So, this is how stabilized commercial real estate is priced.
Say an investor has $1M to invest, and can get $10,000/year with a 1% CD.
The same $1M can get the investor $40,000/year by buying a stabilized 4% Starbucks NNN building.
There is much more risk associated with the Starbucks deal.
The lease will expire one day, it will cost a lot of money to redo the building for a new tenant, you may not be able to get the same rent if they renew, or from a new tenant.
Starbucks closes stores all the time.
There is absolutely no guarantee of the property value increases.
In fact, there is a a very good chance the value decreases if you bought during a low-interest rate environment.
You need much higher yield to justify buying real estate over a CD/gov bond.
Many say that $40k vs $10k justifies the added risk, so they buy the Starbucks.
This has been happening the last 10 yrs.
Money chasing low CAPs due to a lack of other attractive yield products.
Here is what the math looks like on that Starbucks:
$40k/year income, 4% Cap Rate: 40,000/.04% = $1,000,000 Value.
And then — THIS HAPPENS 👇
Suddenly that 1% CD is yielding almost 5x the amount it used to!
Now the choice is: $40,000/year income with a Starbucks, with headache and real estate risk, and potential for lost value
vs
$40,000+ year with a CD or longer term gov bond, no real estate risk.
So, what happens to the value of that Starbucks now?
Well, since CAP rates are just a financial tool that creates yield, rational investors will not possibly buy that Starbucks at $40,000/year.
Obviously, right? It’s just math, no?
If you can get risk-free gov bonds at 4%+ (no state taxes) & CDs in the high 4% range, that Starbucks better offer a higher return to justify it.
What’s your number? That’s up to you, but 4% is irrational.
Is it 6%? Given the risk/reward between the two, absolutely, minimum.
So what happens to the price of that Starbucks?
If a rational investor has adjusted, and wants a premium for the added real estate risk, say they want a 6% CAP:
$40,000/year income / .06% = $666,000 value.
Yes, that is right.
That building is now worth 33% less.
And that is happening all over the place right now in the industry.
Yet, sellers keep insisting on a “4 CAP” or a “5 CAP” as if cap rates have this new meaning.
It’s as if they have nothing to do with interest rates or yields.
But they do. That is all they are.
Next time you come across a 4.5% listing, ask them why it makes sense to settle for 4.5% when you can buy a government bond, today above this.
Tell them that their seller is actually not a seller at all.
And that the word CAP rate still means something.”
