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Cap Rates Are Worthless

Today we're going to talk about why I think cap rates are completely worthless. Cap rates only tell a very small part of the story; it's the current owner's income (which you’re probably going to be able to increase), minus the current owner's vacancy (which might be too high or too low), minus the current owner's expenses (which won’t be the same as yours after closing), equals a net income (that also won’t be the same as yours), divided by the purchase price. The equation is just flawed. It completely ignores any benefits that can be brought to a property's income, the vacancy, and the expenses, and it also ignores two other very important parts; debt and the end value, what the property will be worth in 5, 7, or 10 years. The focus should be cash on cash return, even with principal reduction added back in, and IRR, which takes into consideration the entire hold period including the sale. So, lets’ say we've got a $10 million dollar property that we're borrowing 70% on. And let’s say that after expenses we’ve got a net income of $582,000.  We're going to use a 3.1% rate with a 30-year amortization, and that produces a debt service of $358,000.  Subtract that from the net income and we have a before-tax cash flow of $224,000. If we take the net income of $582,000 and divide it by the purchase price of $10 million dollars, that equals a 5.82 cap rate. In just doing this simple calculation most investors would have walked away. But let me show you why that’s wrong. Here is where the power of debt comes in. Remember, we're borrowing at 3.1% with a 30-year amortization. You have to consider the cash-on-cash return; the return after all expenses and debt is paid. So, at a 5.8 cap that's actually bringing us a 7% cash on cash return. But there's another component that's at play here and that's adding back in the principal reduction. If you plug your debt into an amortization table, you’ll see in this example you have roughly a $30,000 principal and interest payment, of which $12,000 is going to principal each month, which is $144,000 in principal going back into your pocket. That's almost a 12% cash-on-cash return. Now I understand many syndicators have investors to pay, so they really can't count the principal. And I also understand many investors would like to earn 8% cash on cash as that's kind of the gold standard. But sometimes they’ll get down to 6-7% depending on the value add left in the property. Now we’re going to look at the big picture, which is the IRR. The IRR is the money that you have in the property, the cash flows you earned along the way each year, and then the sale of the property in the future. The rest of the explanation is hard to put into words. Watch the full video in the link below for how I show this example on a spreadsheet and the example property produces a 17% per year return. And the question I always ask when an investor wants to immediately turn down a property because it was 5 cap, is did you do the calculations considering that you might be able to increase the rent, or decrease your expenses? My point here is that cap rates only make sense when you’re looking at a fully stabilized property.


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