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Since prehistoric times, we humans have been in the business of evolution. Such is the scientific truth. Unless, that is, we are talking about cap rates, in which case there appears to be no evolution.

It seems the same old misconceptions prevail, and the same lack of conceptual understanding remains. We seem unable to mature in this respect. I am not sure if this article will fall on deaf ears, but I am willing to take another stab at cap rates regardless. I truly hope some of you find this helpful.

What Is Capitalization Rate?

First, let me say this. Cap rate is NOT a metric of investment return, which is why we are careful not to lean on it as our acquisition criteria. Think of cap rate as an indicator of market sentiment.

As investors, we aim to identify the rate at which we can grow our investments on a risk-adjusted basis. All of us have parameters with regard to this, but for all of us, there is a point whereby growth potential outweighs the perceived risk premium by enough of a margin to influence us to take action and to deploy capital.

Well, since in the real estate market risk in large part is defined by a location’s economic fundamentals, for a lot of investors the rationale goes something like this:

I know I have to pay more to be in that location, but because of the superior economic indicators in this location, I feel my money is safer there long-term. Other people think like me and pay more to be in this location, which forces me to pay more to be here. But I am willing to pay more today because I think there will be more sustained growth here in the future. I know that my rate of return may be lower, but safety is paramount to me, so I am willing to accept lower returns.

Benefits of Lower Cap Rates

For many years, I thoughts I was the smart one, buying in Ohio at 10 percent cap and thinking that all those people paying 5 percent cap were stupid. But the more I studied, the more I gained an appreciation for the fact that people buying at low cap rates have already made all the money they’ll ever be able to spend. They are willing to pay a premium for safety instead. And the reason they would go into a market and deploy at 5 percent cap is that they feel their money is safer there than somewhere else.

Benefits of Higher Cap Rates

I am not specifically discussing value-add in this article, which is an integral component but lies outside the scope for today. That said, here’s some rationale.

Clearly, I cannot simply buy a value equivalent to 5 percent cap. Nothing cash flows at 5 percent cap, and I do need some cash flow in order to hold onto the asset long enough for it to do its thing. And unlike those other folks, I still need to create wealth. So, if I must buy at 5 percent cap because such is the market, what I can do is find an asset whereby having paid a price equivalent to 5 percent cap, I can then improve it to where my new income will represent a 7.5 percent cap upon my basis.

Close up of businessman or accountant hand holding pen working on calculator to calculate business data, accountancy document and laptop computer at office, business concept

In this case two things happen:

I will cash flow well at 7.5 percent cap.
I will create a lot of value, because while the re-positioned NOI represents a 7.5 percent cap upon my basis, I am still in a market that trades at 5 percent cap rate. When I go to sell or refinance the asset, this delta of 2.5 percent cap represents millions of dollars of value. This value is what I am really after, since I want to create wealth.
So, in the end, I will have not just the cash flow but also wealth to go with it. Perhaps I should turn that around. In the end, I’ll have wealth and some cash flow to go with it. And I am much more likely to achieve this desired result in a low cap market.