The Difference Between CAP rates and Required Returns

by Landon M. Scott

Every investor is entitled to their own Required Return, but not their own CAP rate!  Hang around a broker’s office for a day and you will inevitably hear real estate investors declare that they will buy nothing for less than such a such a capitalization (CAP) rate.  As in, “find me 50 units in Santa Monica and I require a 10% CAP or greater.”  This is akin to saying to your stock broker, “find me some Apple stock and I won’t pay anything more than $300 per share.” Apple was selling for just under $510 per share at the writing of this post (the examples aren’t perfect since real estate markets are even less efficient than equity markets, but it makes the point). “Good luck!”, the broker says as he rolls his eyes and moves on to the next lead.  The investor in question bemoans the lack of good brokers in the world and calls the next broker.

It’s too bad because nine times out of ten language is just getting in the way. Let’s take a look: CAP rates tell us how much investors are paying for a given stream of income, the Net Operating Income (NOI) of the property. Depending on the location and perceived risks of the property, investors will pay more or less for different properties with the exact same net income.  CAP rates are set by the market.  They exist irrespective of one’s Required Return.  Unless you are willing to make the seller an offer they can’t refuse, or unless the seller lives in a vacuum, expect to pay somewhere close to the prevailing CAP rate, all other things equal (condition of the property, quality of construction, rent control, etc).  Your broker can’t move the market, so as the investor put away the rolodex and contemplate the following: What is my Required Return on the Property?

A multitude of factors can change the Internal Rate of Return (IRR) – a preferred metric in real estate to measure a return for a given period of time. It is true that the purchase price is a significant component of IRR, but it is certainly not the only one.  The job of the investor is to find deals that meet or exceed their minimum Required Return, and unless the investor evaluates them over a realistic holding period they won’t know whether a  property meets their minimum Required Return.  Financing, rehabilitation, use, repositioning, new management, anticipated appreciation and like kind exchange are all examples of things that have a huge impact on Expected Return.

This Expected Return is what the investor is really interested in, whether they express it as such or not.  An investor should purchase a property when the Expected Return is equal to or greater than their Required Return.  It is your job as an investor to understand this and your job as a broker to explain this to your clients. Otherwise, everyone is  just spinning their wheels and talking at cross purposes.

If you are the broker, suggest the client look at the returns of large Real Estate Investment Trusts (REITs) or indexes of REITs. This should provide a good starting point for investors in determining their Required Return. After all, why should an investor go into business for herself and expose herself to individual, non-systematic risk for a return less than what she could get passively in the stock market? Believe me, clients will come up with all sorts of colorful answers, but financial orthodoxy would say they shouldn’t.  Then explain that the REIT return in question is measured over a period of time, whether it’s year to date, annual, or over a period of years.  Next, ask how long they expect to hold the property and look up the corresponding REIT return for a similar period of time.  Finally (and this is the hard part), explain that they need to look at the Expected IRR for a property and consider buying it if that IRR meets or exceeds their Required Return, as roughly approximated by the periodic REIT return you looked up.

Of course I entertain no illusions and am fully aware that many, if not a majority,  of investors not yet familiar with IRR or the concept of Required Return vs. CAP rate will be apprehensive and suspect given that they don’t grasp the concepts.  Many will tell you about how they don’t buy anything they can’t sketch out on a napkin, or provide some overly simplistic metric handed down from their parents/bosses, etc. (cash-on-cash anybody?), but it’s still incumbent upon you as a broker to exercise your fiduciary duty and explain accepted wisdom on the subject.

Note: A common source of confusion arises because many investors only have access to Proforma CAP rates or, rather, CAP rates as advertised by the seller based on a hypothetical Net Operating Income (NOI) in the first year of the new buyer’s ownership. Therefore, given a lack of reliable data, they simply choose a CAP rate they feel comfortable with and tune out the noise caused by widely varying Proforma CAP rates. Brokers, though, should have access to Market CAP rates through listing services and industry surveys.

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