Although the capitalization rate is helpful in comparing the relative value of one property to another, a cap rate doesn’t tell an investor the whole story.  “Cap rates can be confusing because it depends upon what you use to calculate them,” said Bob Anna, Broker Associate for BARBERMURPHY, the largest commercial real estate firm in Southern Illinois. “If you’re basing your decision solely on a cap rate to cap rate comparison, especially during these unusual times, you’ll be making a decision based upon income that might not reflect what the market is going to be.”

By definition, a cap rate is based on a projection of the following 12-month, pro forma net operating income, according to Anna. Advertised cap rates, however, are often based on prior year or trailing 12-month actual net operating income, he noted. “More importantly, cap rates do not account for differences in financing, whether the leverage is positive or negative,” Anna said, “or for future rent bumps, future changes in the tax assessment, reversionary property value at the end of the holding period and other factors. A property with a relatively low cap rate could still offer an exceptional return on investment over the holding period of the asset.”

Investor Raj Tut, Founder and Principal of Gateway Multifamily Group, has acquired, transformed and managed more than $55 million in multifamily real estate over the past eight years. A benefit of Tut’s focus on 40-unit to 100-unit class A and class B apartment developments is that his firm performs its own in-house financial modeling, pro forma and cap rate for each potential deal. “It allows us to determine whether we want to do a deeper dive in considering the investment,” Tut said. “A cap rate is really only giving you a picture of what the deal looks like today, not in the future. We look at a potential real estate investment with a holistic approach, asking ‘What can we do with this property once we acquire it? What’s the neighborhood going to look like tomorrow?’ Depending on these factors and others, we will determine what kind of spread we want between interest rates and the cap rate.”

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Article by Kerry Smith, Informationworks, Inc.