As more people are attracted by commercial real estate investing, we see people coming in from outside industries wanting to learn very very quickly about how the mechanics and the financials in commercial real estate operate.
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What is a Cap Rate?
Rates, for example, are one of the very first questions that new investors anticipate needing to be answered. The way they look at it is like this they’re essentially inverted multiples. A cap rate is an inverted multiple. When you think about in the private equity business EBITDA, you should think of commercial real estate NOI approximately. So EBITDA is approximately the same thing as NOI in the functionality for deriving values. So for instance, a 5% cap is an inverted multiple. So it’s a 20 multiple, a 6% cap is a 16.6 multiple, a 7% cap, a 14 multiple, an 8%cap, a twelve and a half multiple and so forth. And so cap rates are merely inverted multiples for those of you that are coming over from outside industries, notably the private equity space.
What Are Your Investment Goals?
Secondly, a lot of novice investors will essentially look at cap rates as a derivative of value without taking into account their actual goals. Their actual personal goals may be cash flow or long term income stabilization or they want a coupon type of investment. But a cap rate is not a sufficient manner for driving any of these because cash flow is indicative of the debt quality and cap rates do not take into account the quality of the debt. So debt is often more times than not more important than cap rates.
Thirdly, cap rates disregard occupancy and that a lower occupancy should be able to have a higher upside yield and therefore can command a lower cap rate. You’re paying a higher multiple for lower occupancy because there’s greater upside potential. Cap rates also disregard the potential. They disregard the upside from things like mispriced leases or expiring bad leases that you have the opportunity to build to take up the market. So cap rates are not a very good standard of metric for evaluating a real estate investment.
And finally, a cap rate disregards the asset back risk profile that investors should be taking into account as they look at their entire portfolio both in commercial real estate and outside commercial real estate. So what’s better to use than a cap rate? Well, one of the standard metrics is a moic or a multiple on the equity or an equity multiple which we’ll have another video about that shortly. Another great opportunity is to look at the cash flow in the internal rate of return over this given hold period. Mortgage does not take into account a whole period, but an IRR properly derived from a proper cash flow forecast. We’ll be able to give you an idea about intended cash flows and intended net and gross shields off the investment. Hope this helps you better understand the idea of a cap rate and its function within the commercial real estate space.