Does a Good Cap Rate Mean it’s a Good Deal?

The past several years have been forgiving to commercial real estate investors. You could go out, buy a building, lower the rents, and sell the property for more than you paid for it. Huh?

Sounds strange doesn’t it? Imagine this, you’re a savvy real estate investor who’s interested in purchasing a 40,000 SF office building located minutes from the highway and is 100% occupied. The asking price is attractive–it’s priced on a 9 CAP rate. It has a net operating income (NOI) of $600,000 and your 70% LTV debt will cost you 7.5%. You pay $6.6M for it.

Now, looking at this deal, you know two things for sure. The CAP rate is far higher than the cost of leverage on the property, so there’s a pretty good bet that you’re going to be cash flow positive right out of the gates on this one. The second thing you know is that you’ve got a full building, teeming with strong tenants that are are paying on multi-year leases. Looks pretty good, doesn’t it?

So you buy it. You collect your cash flow each and every month. Things are going great. Then the market begins changing. Another investor has seen that you’re 100% full and charging great rents, so he decides to build a new 50,000 SF office building 2 blocks down the street. It’s one of those new “green” buildings with modern architecture, the latest amenities, and guess what, your new neighbor’s going to be charging 10% less rent than you are. Worried? You should be.

Over the next year, your building begins to increase in vacancy , as your tenants let their leases expire and move down the street. The remainders start picking at your rents trying to renegotiate their rates because they figure you’re getting anxious and are afraid they’ll leave too, if given the opening. You rewrite the leases, keep the building, and now have 85% occupancy. Your net NOI is $442,000. Nasty, you’re now out $158,000 per year.

Then some guy who says he’s from San Diego calls you and makes you a cash offer. He offers you a 6 CAP or $7.36M. He figures that he’s not going to earn 6% during the next 12 months in the stock market and is betting that he’ll be able to sell your building to the next guy for even less than a 6 CAP without doing much to it.

Guess what, you just hit it big. You’re now going to sell that building for more than you paid for it, grossing $700k, despite the fact that you were collecting less rent and experienced an increase in vacancy over the past few years. You just made money to take your building the opposite direction you were supposed to. This story ended in the third quarter of 2007.

How about now? Bad news. The market’s changed and those CAP rates are going up, which means that values are going to be coming down. You’ll no longer be able to buy a building and expect to sell it for more than you paid for it, even if your operating fundamentals deteriorate, because investors see that the future is uncertain and they want their initial investment back faster.

If you’re buying on CAP rates today, you should know that you may be buying yourself a major problem. CAP rates give you a glimpse at 1 year’s operating performance for your property without taking into consideration the cost of financing, reserves, commissions, taxes, or most importantly, the overall holding period.

Be warned, there are better tools out there for evaluating deals. And if you’re just using the one that worked for the past 7 years, you may be unpleasantly surprised at what you don’t get in return.

By the way, where should we send your free 10 part email mini course?  It’s 100% commercial real estate investing focused and you can get it here.

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