In this video, we’ll be looking at capitalization rates, commonly called cap rates, and their reliability when making decisions about investing in apartment buildings. But first, what is a cap rate and how is it used?

A cap rate is used in commercial real estate to indicate the expected rate of return generated on an investment property. It is calculated by dividing net operating income or income after operating expenses by the property price. The result is expressed as a percentage. It is used to estimate the investor’s potential return on their investment property.

Let’s Compare Two Properties

Let’s take a look at two properties selling for the same price and determine which one we should buy. Both Building A and Building B are selling for $10 million. Building A is producing $500,000 in net operating income, or NOI. Building B is producing $425,000 in NOI. If we were to calculate the cap rate, we would see that Building A is generating 5%, and Building B is generating 4.25%. Obviously, a 5% return is better than a 4.25% return, so Building A seems to be the better investment.

We have to be careful, though. People often place too much importance on cap rate when forming an opinion about a property’s investment value, especially a new purchase. However, cap rate on its own is often misleading. Cap rates can fail to tell the whole story. Let’s do some due diligence on the buildings to see how they really compare.

The Importance of Due Diligence

After conducting physical inspections of the buildings, we see that Building A requires some major repairs. It needs a new roof, and there is structural damage to the underground parking lot that needs to be fixed immediately. Those repairs are going to cost $1.4 million. Building B is in good shape, but needs repairs to the elevators, which will cost $100,000. If we add these costs to the purchase price, Building A is going to cost $11.4 million, and Building B will cost $10.1 million.

Conducting some further financial due diligence, we see that Building A’s rents are below market and we can raise them to generate another $50,000 in rent, for a total in a NOI of $550,000. We have a similar situation in building B where rents are below market by $90,000 and we could be generating $515,000 in NOI.

With our new information, we see that Building A is going to cost us more to buy, but it also generates more NOI than Building B. So should we spend more to get more income? Which property is the better buy?

It’s not as obvious as when we first looked at them. Using all the additional information we gathered during due diligence, we can now calculate what we call the intrinsic cap rate of Building A and Building B. Let’s see what that looks like.

Calculating “Intrinsic” Cap Rate

Taking our cap rate formula, let’s use the new information. The true cost of purchasing the property is the purchase price plus the cost of repairs. While the new NOI is the existing income plus the additional income from increasing rents. Now Building A has an intrinsic cap rate of 4.8%, and Building B has an intrinsic cap rate of 5.1%.

At first, Building A seemed to generate the better return. But after including new information discovered during due diligence, we see that Building B actually has a better return and is a better investment.

While this example is a simple one, it demonstrates that looking at an individual building’s cap rate does not necessarily give you a clear indication of whether it’s a good investment or not.

Looking Beyond Cap Rates

Make no mistake, cap rates are useful and important tools in real estate analysis, but you need to be cautious about drawing conclusions using that number alone. It is important to remember that the cap rate at the time of purchase is only an estimate of your return from the income portion of an apartment investment.

Your total return from an apartment comes from three sources:

• Rental income
• Increases in equity from paying down the mortgage
• Increases in the value of the property over time

All three of these components, in addition to the use of leverage for mortgages as well as taxes, need to be evaluated when making an investment decision.

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