Is purchasing higher cap rates properties the best strategy?

05/08/2021   |   By Chahinez Dib

When it comes to investing in properties, some investors tend to search for a higher capitalization rate (also known as cap rate). Unfortunately, that is one big mistake. 

As real estate investors, you must transition from the mindset of a consumer to the mindset of an investor. How do you do that? First off, you need to understand the difference between price and value. More than often, people will mistake price and value as the same thing, which is not. If you are buying a bottle of Pepsi, and two stores across from each other offer the bottle at a different price, you are right to purchase the bottle from the store that sells it for less. When looking at investment properties, however, you should not be considering price as the main factor as what you are purchasing is not a commodity but an investment, a revenue or equity generating machine. 

Consumers look at many things but they tend to focus on the price whereas investors must consider value. Thus, it is important to distinguish value from price. When we’re looking at an asset that generates cash flows, either annually or on the overall duration of a project, as a real estate investor you cannot only consider the price. Price is but one of many expressions of value.

Price is the amount of money a seller is asking for a property whereas value is intrinsic to a property and the investor. Value creates demand, which influences price. It is important to note that value alone cannot influence price without the demand function. And demand is not just a blanket concept, it oscillates and is also different between time periods, types of investors, etc.

Here goes value investing. It is not only about purchasing something at a lower price and selling it at a higher price. It goes beyond that. It is about purchasing something at a price lower than its actual or potential value. Thus, it will create an arbitrage on the value you, as an investor, will now detain with that asset. 

“Value investing is all about understanding the intrinsic value of a property and not necessarily looking at the price because the price is not necessarily value,” says CEO of the MREX, Nikolaï Ray.

This ultimately brings us to the discussion of cap rates, being that price in multifamily is a function of net operating income and the cap rate. Most people’s definition of cap rate is Net Operating Income (NOI) divided by the purchase price. The ratio—expressed as a percentage—is an estimation for an investor’s potential return on a real estate investment if this asset was purchased without using any leverage 

For investors, it can be more efficient to use a cap rate more proactively in order to see if they are properly priced in relation to value in the market they are trying to invest in, or how is this specific market performing versus another.

As opposed to what many people may think when they are buying or looking to buy properties, a market does not have a specific cap rate but rather a range of cap rates. In our latest webinar “Should you really invest in higher cap rate markets” MREX’s CEO Nikolaï Ray gave multiple examples of how to calculate a cap rate and how to analyze it. 

In this webinar, Ray used the Gordon Growth Model. As Ray explains, when using the Gordon model, we are looking at a pricing cap rate—which means we are trying to proactively price what we are doing, thus deriving the right value from it. 

“The Gordon model is a proactive way to measure the cap rate, determining the cap rate whereas the NOI and price is simply a result,” adds Ray.

How to use the Gordon Growth Model

Cap rate is best understood as a measure of returns and risk. In this example above, we’ll use the Gordon model in order to evaluate the cap rate of a particular market. 

To begin, the Gordon Model shows the cap rate as being the result of R minus G. R is composed of the risk-free rate—which is usually a 10-year treasury bond rate. As an example, let’s say that we are currently at a two percent 10-year treasury bond and we double that return as a risk premium. Therefore, we want a four percent of return on top of our two percent bond rate. If we do the math, our R would thus be six percent.

Let’s also say that we are projecting a two percent annual growth of NOI in this specific market that we are looking at. Thus, what we do is take our six percent and subtract our two percent growth. Essentially, this market will be priced at an average cap rate of around four percent.

The Gordon model will usually be used to price a market, a neighbourhood, properties, etc. 

That being said, Ray explains there is a time to use NOI divided by price and there is a time to use the Gordon model. While the reactive way is to simply take NOI and the purchase price of a property and derive the cap rate from it, the Gordon model is a proactive way to measure the cap rate and to determine it, 

“They’re two different things and you don’t use them at the same time,” he adds.

Three Truths about Cap Rates

Of course, many other things come into play when calculating a cap rate. Ray shares three truths about why looking at higher cap rates when purchasing properties is not the best strategy. 

The first truth is about cap rates and rates being inversely correlated especially when looking at different markets. Essentially, it means that lower cap rate markets have higher rents and higher cap rates have lower rents. Thus, there is an inverse correlation between the two. 

The second truth Ray discusses in the webinar is that cost-basis changes very little between markets. For example, if you are renovating a 10-year-old apartment building in Orlando, Florida, versus Cleveland, Ohio, the cost basis is going to be very similar. If you are doing renovations, you most likely want to bring the building back to the closest to a new property as possible. 

If you decide to do a ground-up construction, what will change between the two markets, is the cost-based price of the land that you are building on. However, that is often balanced out by the potential rents you can get in that market versus the price per door value of the land that you are building upon. 

Finally, the third truth Ray reveals is that lower cap rates equal higher output value-wise. Not to give you all the good lines, I recommend that you watch the full webinar below. In this 40-minute talk, Ray shares plenty of key insights that real estate investors must understand and discusses other levers in the wealth creation process that can help you make better acquisitions.