Dec 02, 2008

Cap Rates are not an Indication of Investment Performance

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By: Dave Girardot

Cap Rates are not an Indication of Investment Performance

When asked to do an investment performance analysis for a client, I do use the Capitalization Rate (Cap Rate) to sort through potential deals.  It is a down and dirty number to look at when trying to sort through multiple investment opportunities and determine which investments warrant a closer look.  But where the rubber really meets the road, the Cap Rate is not a good indication of the investment performance of a particular property.

The Cap Rate is simply a ratio of the first year’s net income divided by the purchase price.  It does not give you any indication of the projected return of the investment over the life of the investment.  To do this you really need to calculate the Internal Rate of Return (IRR) over the holding period of the investment.  Internal Rate of Return is a Discounted Cash Flow measure.  It takes a look at all the “up front” money paid by the investor to purchase the investment, the annual cash flows out of the investment and the net proceeds upon liquidation of the investment.  It also takes into account the financing involved, any potential rent increases, escalating expenses and the tax ramifications to the investor. 

Here is a good example of why the initial Cap Rate at purchase is a bad indicator of actual investment performance over the holding period of the investment.  Let’s take a look at two buildings.

Building A is an older building with multiple tenants.  All of the tenants are on a month-to-month lease.  The net income of Building A the year of purchase is $45,000.  The asking price of Building A is $500,000.  The Cap Rate at purchase is 9%.

Building B is a newer building with a single tenant.  The tenant is on a ten year lease.  Building B has a net income the initial year of purchase of $34,000.  The purchase price is also $500,000 and the Cap Rate at purchase is 6.8%.  Strictly using the Cap Rate at purchase, Building A looks like a much better buy with an additional 2.2% of income or $11,000 based on the purchase price during the first year of ownership.

Both leases are triple net with all of the expenses except capital improvements passed on to the tenants.  Building A has $2,000 of additional maintenance that cannot be passed on to the tenants.  This will start on year 2 and continue during the entire holding period.   Building A also will need a new roof in year 4.  Estimated cost of the new roof is $12,000. 

Building B is newer and only has $1,000 of additional maintenance annually that cannot be passed on to the tenants.  This will start year 1 and continue during the entire holding period.  The tenant of building B has agreed to pay a CPI increase in rent annually.  CPI increases are estimated to average 3.5% every year.

Both buildings will have the same financing involved and also will be held for a period of seven years.  The disposition price will be estimated using an 8% Cap Rate of the estimated net income of year 8 for both buildings.  Both buildings will have a cost of sale of 6% of the sales price.

Now let’s look at the Internal Rate of Return of both buildings.  Building A that had a much better Cap Rate at purchase, has a projected IRR of 5.5% on a before tax
basis.  Building B has a projected IRR of 9.6% on the same before tax basis.

As you can see the IRR on Building B is greater than Building A by 4.1%.  This is a very big difference between the two investments.  Not only is the rate of return on Building B a lot better than Building A, I would also consider it a much safer investment.

It is vitally important to do this type of analysis before purchasing any commercial income property as an investment.  Always consult with a commercial property specialist to do this type of analysis before making your final decision to purchase.  And remember, Cap Rates are not a good indication of the investment performance of income producing property.

Dave Girardot, CCIM
406.212.0112
dave.girardot@coldwellbanker.com

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