On the very first day of Business School in Finance, the first thing that is taught is TINSTAAFL (There is no such thing as a free lunch.) That is probably the most important thing you learn and much of finance then builds on this concept. So, if something sounds too good to be true, it probably is not true. To be sure, there have been times where this skepticism has prevented me from trying some things that ultimately became lucrative but more often it has prevented me from getting involved with things that didn’t pan out.
In today’s business environment, we are seeing interest rates paid by financial institutions of 1% or 2%. The 30 year mortgage rate now is just a little more than 4%. Yet in Commercial Real Estate, we see cap rates being quoted at 10% to 12% for Commercial Investment Properties. So, one has to wonder, why isn’t this a slam dunk? Why isn’t money pouring into these investments? After all, if this is true, this seems like a license to print money.
In some cases, money is flowing toward these investments but before putting your life savings into one of these investments, refer to the opening paragraph – There is no such thing as a free lunch. In many cases, these deals simply are too good to be true. Understanding Investment Property and the way that these cap rates are figured is crucial to your decision to invest.
A cap rate is much like an interest rate. It is an expression of the equivalent return on a series of cash flows. It is based upon the concept of discounted cash flow, which will provide you with a present value of a series of cash flows that extend into the future. It turns out that if you assume that these cash flow last forever (are infinite) that the calculation is quite simple. (PV = CF / discount rate). To get cap rate, we simply rearrange this equation. (discount rate = CF / PV). For these purposes, we then call the discount rate the cap rate, use the sales price as the PV and use whatever the annual income is for the property as CF.
Well, the devil is in the details. First of all, we are assuming that the cash flows are certain and infinite. If you have a strong tenant and a long term lease, this is not really a killer. For periods of about 20 years or more, this is still a good estimate. Unfortunately, people are using these methods to calculate cap rates for much shorter lease terms when these cash flows are much less certain. Complicating this further, in some cases cap rates are being determined by assuming lease rates and terms for properties which are not fully occupied.
A follow up assumption is that the market is setting these high rates when properties devalue. Once again, if you have a quality property with a long term lease and a quality tenant, that is probably a good assumption. On the other hand, if you do not have all of these features, the market may simply be discounting the value of the asset because it understands that the lease terms are not long term or certain. Accordingly, the market understands that there may well be periods of vacancy and subsequent leases may be at reduced rates similar to current market conditions. That is of course, hard to measure but if you could measure it, I suspect you would end up with an expected cap rate more in line with interest rates offered by other investment choices.
A purist might claim that the market is correctly calculating the cap rate and that the high rate simply reflects increased risk associated with this investment opportunity. However it is clear that not all investment properties choices are equal. Given equal cap rates, a property with long term leases in place with a low risk tenant would clearly be a better investment than one having short terms leases or weak tenants which simply assumes everything will work out.
