4 reasons why cap rates are misleading

Be mindful when analyzing/comparing cap rates

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4 reasons why cap rates are misleading

Last week, I promised to write about cap rates in the context of valuation.

A lot can be said about this topic, but if there’s one thing you learn today let it be this: most people rely on cap rates too much when evaluating LP investment memos.

4 reasons why cap rates are misleading:

1. length of lease

2. creditworthiness of tenant

3. diversification of lease stream

4. in place vs market rent

First, some background:

Capitalization rate (or "cap rate") = Net Operating Income (or NOI) / Purchase Price.

There are some variations on this such as Unlevered Yield on Cost, which I will write on in the future.

Let’s dive in:

1) length of lease

You see "11% cap" on LoopNet and get excited.

What's wrong?

Cap rates aren't created equal and you realize that there's only a year left on the lease.

In other words, this 11% cap rate isn't comparable with an 11% cap rate with 10 years remaining on the lease, since there's lease up (finding a suitable tenant) and TI (funding dollars into the building to attract a tenant - acronym for Tenant Improvements) risk within the next year.

Since it’s unclear when you’ll find a tenant, carrying costs upon vacancy need to be vetted deeply (property taxes, insurance, and other costs that the landlord has to continue paying despite having no income)

2) creditworthiness of tenant