Welcome back to the Deep Dive. I want to start
today with a scenario that used to drive me absolutely
crazy. Okay, I'm listening. You're scrolling
through real estate listings on a Saturday morning,
because that's what we do for fun now, and you
see this rundown duplex in the middle of nowhere.
Yeah. Let's say it's listed for $100 ,000. Okay.
I can picture it. Peeling paint, maybe a chain
link fence. Exactly. And then you switch tabs
to some high -end commercial listing site and
you see a single parking spot. And I mean literally
just a slab of concrete with painted lines in
downtown Manhattan or maybe Hong Kong. Right.
And it is listed for the exact same price, $100
,000. It happens more often than you'd think,
especially in dense cities. It does. As a normal
person, you look at that and you think, OK, the
price tag is the same, so they must be worth
the same. Just simple logic. But then you talk
to a professional investor and they almost laugh
at you. They tell you the parking spot is a safe
haven and the duplex is a money pit. Or depending
on the year, maybe it's the other way around.
The point is they're seeing a layer of data that
is completely invisible to the price tag. They
aren't looking at the price. They're looking
at the engine inside the price. Exactly. And
that engine. is what we are going to take apart
today we are tackling the capitalization rate
or as everyone calls it the cap rate the infamous
cap rate and i'll be honest when i first saw
this topic in our research stack i wanted to
run it sounds like the driest most boring piece
of financial jargon imaginable it sounds like
homework it really does it sounds like something
you learn in an accounting class you're trying
to sleep through but as i went through the cbre
data the inquiry i have historicals and the case
studies we have for this deep dive especially
that Stuyvesant Town disaster in New York, I
realized I was completely wrong. It grabs you
once you get into it. It does. The cap rate isn't
just math. It's a universal translator. It's
the only tool that lets you compare that Ohio
duplex to a Manhattan skyscraper and actually
understand which one is the better bet. That
is the perfect way to frame it. Think of the
cap rate as a thermometer. If you walk up to
a building, the price tag tells you the size
of the building. Maybe it's grandeur. Right.
It's physical presence. But the cap rate tells
you the temperature of the market surrounding
it. Is it overheating? Is it freezing cold? Is
it a risky bet that might burn you or a safe
bet that will take, you know, 30 years to pay
off? It's a vital sign. So our mission today
is to give you, the listener, that thermometer.
We're going to move beyond the basic arithmetic.
though we will absolutely do the math, and look
at the story this number tells about risk, about
market psychology, and about the future. We're
going to look at the math, but we're mostly going
to look at the psychology behind the math, because
ultimately real estate value is just a collection
of human expectations about what the future holds.
I love that. Okay, so let's start at the very
beginning. Section one, the core mechanism. If
I'm at a cocktail party and I want to sound smart,
how do I define a cap rate? Without boring everyone
to death. At its most basic, most fundamental
definition, the capitalization rate is a ratio.
Okay, a ratio of what to what? It is the ratio
between the annual rental income produced by
a real estate asset and its current market value.
So income divided by value. Precisely. The formula,
if you want to write it on a napkin, is capitalization
rate and annual net operating income current
value. Okay, and we're going to spend a lot of
time on that net operating income part. Because
it's tricky. Oh, it's a minefield. But before
we do, I need a simple example, a back of the
napkin example. Let's say I'm buying a building.
Let's stick to the primary example from our source
material. The math is very clean. Imagine a building
is purchased for a sale price of exactly $1 million.
Okay, I've got a million -dollar building. And
let's say that building produces $100 ,000 in
positive net operating income, or NOI, in a single
year. Okay, so $100 ,000 in income. To get the
cap rate, you take that $100 ,000 of income and
you divide it by the $1 million cost. $100 ,000
divided by a million. That's .10. So 10%. Correct.
The capitalization rate is 10%. Which means what
exactly? Does that mean I made a 10 % profit
on my money? In a way, yes. It means that in
a single year, one -tenth of the building's total
cost is paid for by the net proceeds it generates.
It's a yield. If you put that million dollars
into a high -yield savings account, the interest
rate would be your yield. I see. In a building,
the cap rate is your yield assuming, and this
is a big assumption for now, that you paid all
cash. Okay, so it's like the building's annual
dividend. That brings up this concept from the
sources of the payback period, right? Yeah. Because
if I'm getting 10 % of my money back every year,
simple math says it takes me 10 years to get
my million bucks back. Exactly. Capitalization
rates are an indirect measure of how fast an
investment pays for itself. At a 10 % cap rate,
the payback period is 10 years. One divided by
0 .10. Now let's flip it. Imagine a different
scenario. Same million -dollar building. Looks
identical from the outside. But the cap rate
is 5%. So wait, for it to be 5%, that means the
income must be lower. Same million -dollar price
tag, but now it only makes $50 ,000 a year in
NOI. Right. $50 ,000 divided by a million is
5%. Now what's your payback period? Well, one...
Divided by 0 .05. That's 20. 20 years. 20 years.
So here is where it gets really interesting.
And this is the part that is so counterintuitive
for beginners. Right. If you see a building with
a 10 % cap rate and another one with a 5 % cap
rate, your gut instinct, your immediate reaction
is to say. Wow, 10 % is way better. I get my
money back faster. Double the return. Of course.
Yeah, obviously. Who wants to wait 20 years to
recoup their investment when they can wait 10?
In almost any other part of life, faster and
higher returns are better. But in the world of
professional real estate, a lower percentage
often, not always, but often signals higher quality.
Wait, unpack that for me. How can a lower return
possibly mean higher quality? It just feels wrong.
Think about it from the perspective of risk.
Why would any rational investor accept a 5 %
return and agree to wait 20 years to get their
money back? What has to be true for that to be
an attractive deal? Well, they wouldn't unless.
Yeah. Unless they were incredibly sure they were
actually going to get that money. Right. Like
rock solid sure. Exactly. They accept a lower
return because they believe that income stream
is incredibly safe and reliable. Or, and this
is another piece of it, they believe the value
of the building itself is going to skyrocket
in the future. So they're paying a premium for
safety or for growth? Precisely. They are willing
to pay more money today for that stream of income,
which pushes the cap rate down. Conversely, if
a building is offering you a 10 % cap rate, or
a 12 % cap rate. It's probably risky. It's the
old, if it sounds too good to be true, it probably
is rule. That's the first question a pro asks.
What's the catch? Maybe the tenants are on shaky
ground and might leave next month. Maybe the
roof is about to cave in and needs a $100 ,000
repair. Maybe the whole neighborhood is declining.
The market is forcing the seller to offer a high
-yield... a sweetener, if you will, to attract
a buyer to take on that mess. So a high cap rate
often means cheap building, high risk, while
a low cap rate often means expensive building,
low risk. That is such a crucial distinction.
The cap rate isn't just what you get. It's what
the market demands you get to convince you to
take on the associated risk. Yes, it is the price
of risk quantified as a percentage. OK, that's
a huge piece of the puzzle. But before we get
too deep into the psychology of risk and growth.
We have to talk about the inputs. We keep saying
net operating income or NOI. And I feel like
there's a giant trap here. There is. Because
income can mean so many things. If I ask my accountant
what my income is, he gives me one number. If
I ask the IRS, they give me a totally different
number. This is the single biggest mistake people
make when they first try to value real estate.
We are in section two now. defining income correctly
that numerator in the fraction the top number
is net operating income it is not just profit
in the loose sense and it is absolutely not cash
flow okay so let's distinguish those for me what
actually goes into calculating noi step by step
you start with gross lease income that's all
the rent checks you collect plus any other income
like from laundry machines or parking fees the
total amount of money that comes in the door
right Then from that, you subtract the fixed
and variable operating costs, the things you
have to pay for to keep the building running.
So property taxes. Yes. Even though you hate
paying them, they are a direct cost of operating
the business. They come out. Insurance. Yes,
property insurance. That comes out too. What
about fixing the toilet that broke in Unit 3
at 2 a .m. on a Sunday? Absolutely. repairs and
maintenance you also subtract landscaping snow
removal any utilities the landlord is responsible
for property management fees if you hire someone
all those are operating costs necessary to keep
the building functional and rented okay so far
so good that all seems logical now what is excluded
what do we purposefully leave out of the mass
that might surprise people this is the critical
distinction first you exclude depreciation That's
a non -cash tax write -off. It's an accounting
concept, not a real expense. Okay, makes sense.
You also exclude the owner's personal income
taxes. And this is the big one, the one that
everyone gets wrong. You exclude mortgage interest,
also known as debt service. Okay, I have to stop
here because we just hit the most controversial
part of the formula. You were telling me we exclude
the mortgage payment. Correct. You do not subtract
debt service when calculating net operating income.
But hold on a second. That sounds completely
insane. If I buy a building, the mortgage is
the single biggest check I write every single
month. It leaves my bank account. It is a very,
very real cost. If I ignore it, aren't I just
lying to myself about how much money I'm actually
making? You're asking the exact right question.
If you were calculating your personal cash flow,
the money you can take home and spend on groceries,
then yes, ignoring the mortgage would be lying.
But remember our mission. The cap rate isn't
about you. It's about the building. Make that
make sense for me. I'm struggling with this.
Why does the building not care about my mortgage?
Okay, let me give you an analogy. Picture two
identical buildings, building A and building
B. They are right next to each other, built by
the same contractor, same floor plans, same tenants,
same rent. They both bring in $100 ,000 a year
in NOI. Okay, they're identical twins. Exactly.
Now, building A is bought by a massive pension
fund, let's say a teacher's retirement fund.
They have billions in cash. They pay all cash
for the building. No mortgage. No debt. Must
be nice. Right. Now, building B is bought by
a young investor who scrapes together a small
down payment and borrows 90 % of the purchase
price from the bank. He's leveraged to the hilt.
Okay. So building A has no mortgage payment.
Building B has a massive one. A huge one. So
if we included the mortgage in the valuation
calculation, building A would look like a gold
mine. Huge positive income. Building B would
look like a total disaster, almost zero income
because it's all going to the bank to pay the
loan. Right. On paper, they look like completely
different investments. But are they physically?
Are the assets themselves different? They are
the same pile of bricks. The roofs are the same.
The tenants are paying the same rent. The buildings
are performing identically. Right. The bricks
haven't changed. Only the owner's financial situation
is different. And that is exactly why we use
the cap rate. It strips away the financing structure,
which is unique to each individual buyer, and
it looks purely at the underlying asset performance.
It lets you compare assets on an apples -to -apples
basis. I see. So it allows the pension fund to
look at BuildingBee and say, I don't care that
the current owner is broke and overleveraged.
The machine itself produces $100 ,000 a year.
Precisely. It isolates the real estate quality
from the financial engineering. It answers the
question. If you paid all cash for this asset,
what would its unlevered yield be? That makes
total sense. It clarifies the view. It took me
a minute, but I'm there. But there's another
trap you mentioned from the source material.
They called it the undefined trap. Yes, this
is a fun mathematical quirk that actually teaches
an important lesson. This happens with inherited
buildings, right? Right. It's the classic example.
Let's say your great aunt Mildred leaves you
a 10 -unit apartment complex in her will. You
get it for free. Your cost basis, what you paid
for it, is zero. Best day of my life. Financially,
yes. But if you try to calculate your return
on investment based on what you pay... Well,
the income is, say, $50 ,000. Yeah. And I divide
that by my cost, which is zero. What happens
when you divide by zero? The universe implodes.
It's undefined. Your calculator gives you an
error message. Exactly. You cannot calculate
a cap rate based on initial cost if that cost
is zero. And this brings us to a vital point
that leads to our next section. Cap rates should
always... always be calculated based on current
market value, not your historical cost. Which
segues perfectly into section three, the time
value of money and the sneaky, powerful concept
of opportunity cost. Because this is where people,
especially long -term owners, trick themselves.
They do all the time. We call it the 20 -year
owner scenario. It's a classic mental error.
Walk us through this one. Okay, let's look at
the detailed example from our source material.
An owner, let's call him Frank. bought a building
20 years ago for $200 ,000. It was a great deal
at the time. Okay. Frank's feeling pretty good
about that purchase. He is. Today, that building,
due to market appreciation, is now worth $400
,000. And the NOI, the income it produces after
expenses, is a very healthy $100 ,000 a year.
Not bad at all. Frank's doing well. Now, you
go to Frank and you ask him, Frank, what is your
return on this building? He'll often look at
his original checkbook. He'll pull out the old
file. He remembers the day he wrote that check.
He does. And he says, well, it's simple. I paid
$200 ,000 and it makes me $100 ,000 a year. That's
easy math. I'm making a 50 % return. And he feels
like a genius. He's probably bragging about his
50 % return at the golf course. He feels like
Warren Buffett. But he is wrong. He's fooling
himself. Why is he wrong? I mean, 100 ,000 divided
by 200 ,000 is 50%. The math works. The arithmetic
works, but the economic logic is flawed. He is
ignoring the $400 ,000 that the building is currently
worth. He's ignoring the value that's sitting
right there on the table. What do you mean? By
choosing to keep the building today, he is effectively
choosing not to sell it for $400 ,000. That $400
,000 is the real amount of capital currently
tied up in this deal. So the real math, the correct
math, is the $100 ,000 of income divided by the
$400 ,000 current value. Which gives you what?
A 25 % cap rate, which is still amazing, by the
way. Most investors would kill for that. But
it's not 50%. It's not 50%. And this is the core
of opportunity costs. Explain that concept. Think
of it this way. Every single morning you wake
up and you don't sell your house, you are effectively
buying it again at today's market price. Ooh.
That is an uncomfortable thought. It reframes
ownership entirely. It is uncomfortable, but
it's the truth for a rational investor. Frank,
in our example, is effectively buying that building
for $400 ,000 every single day by not selling
it. So the real question isn't what's my return
on my old money? The question is, is 25 % the
best return I can get on my $400 ,000 today?
Right. Could he sell it, take that $400 ,000
and put it into stocks, into bonds, into a different,
better building that yields 30 %? Exactly. The
market doesn't care what you paid in 1995. The
market only cares what that capital is worth
today and what it could be doing instead. That
is a huge mindset shift. It stops you from being
sentimental about an asset. Oh, I've owned this
for 30 years. That doesn't matter. Real estate
is no place for sentimentality if your goal is
to maximize returns. So let's move to Section
4. The three levers. We know what the cap rate
is. We know how to calculate it properly. But
what actually moves it? Why is it 5 % in one
city and 10 % in another? Why does it change
from year to year? There is a scary -looking
formula in our notes. Cap rate, risk -free rate,
plus risk premium growth rate. It looks complex,
and the full academic version is even worse.
But we can simplify this into three core drivers.
Think of them as three levers that are constantly
pulling the rate up or pushing it down. Okay,
good. Let's play a game with this. I'll name
the lever from our research, you explain how
it works, and then I'm going to give you a hypothetical
building scenario and you tell me how the lever
applies. I like it. Let's do it. Okay. Lever
number one, the opportunity cost of capital.
This is usually tied to what's called the risk
free rate which is the yield on government bonds
like a 10 year U .S. Treasury. Why that because
commercial real estate competes with other assets
for investor dollars. If I can get a 5 percent
guaranteed return by buying a U .S. Treasury
bond backed by the full faith and credit of the
government. Why would I buy a building for a
4 % return and have to deal with tenants, toilets,
and taxes? You wouldn't. It's a no -brainer.
So if bond rates go up, making them more attractive...
Then demand for real estate goes down. Investors
move their money to the safer, easier asset.
Exactly. And when demand for real estate falls,
prices fall. And as we know from our formula,
if the value, the denominator, goes down, the
cap rate goes up. Okay, scenario time. I am selling
a generic, boring office building in a generic
city. It's fine. It's okay. Class B, 90 % occupied.
But suddenly, the Federal Reserve hikes interest
rates by 2 % to fight inflation. What happens
to my cap rate? Your cap rate almost certainly
goes up. Because your building is boring and
stable, it doesn't have some crazy growth story.
It's competing directly with those bonds for
capital. If bonds now pay more, you have to offer
a better yield to compete. The only way to do
that is to lower your price, which pushes your
cap rate up. Ouch. The Fed just cost me money,
even though my building didn't change at all.
The Fed just repriced your entire asset class.
OK, lever number two, growth expectations. This
is the greed lever, the sexy one. I like this
lever. If rents in a market are expected to rise
dramatically, say you're in a booming tech hub
like Austin or Miami in the right year. Investors
will pay a huge premium to get in today. They're
willing to accept a tiny amount of income right
now because they believe that income will double
or triple in five years. Yes. So a higher price
for the same income equals a lower cap rate.
It's like buying a growth stock. You buy a Tesla
or Amazon back in the day. You're not buying
it for the dividend they pay now, which is zero.
You're buying it for the future earnings. It's
the exact same logic. A low cap rate often signals
the market has very high growth expectations.
OK, scenario. I own a pretty standard warehouse.
But it's not just any warehouse. It's located
right next to the main airport, in a city where
a major tech company just announced they are
building their new massive headquarters. The
growth lever gets pulled all the way down hard.
Investors will be falling over each other to
buy that warehouse. They'll bid the price up
so high that the CAC rate might drop to 3 % or
even 2 .5%. Wow. They don't care that the yield
is low today because they know that in five years,
every company that wants to be near that new
headquarters will need logistics space, and your
warehouse will be a gold mine. They're buying
the future. Got it. Okay, last one. Lever number
three. Risk. The fear lever. The opposite of
the greed lever. Right. Risk moves in tandem
with cap rates. It's a direct relationship. If
you have a high risk asset, maybe has a single
tenant, a startup that might go bankrupt or it's
in a bad location in a shrinking city, an investor
is going to demand a much higher return to take
on that risk. They need a bigger cushion in case
things go wrong. You got it. High risk equals
high cap rate. And the flip side is true. Low
risk like. A brand new building in a prime location
leased to the federal government for 20 years.
That's going to have a very low cap rate. Okay,
scenario. I own a shopping mall. It was built
in 1980. The anchor tenant was a Sears, and they
just went out of business and closed. The roof
leaks. And it's located in a town where the main
factory just shut down and the population is
dropping. Oh, boy. That is the fear liver maxed
out and then broken off. That is a trifecta of
pain. What happens to my cap rate? No one wants
that headache. To sell that property, you would
have to drop the price so low that you're offering
a massive cap rate, maybe 12%, 14%. It could
even be higher. You are basically paying someone
to take this disaster off your hands, and you're
compensating them with a huge yield for the sleepless
nights they're about to have. So if I'm a buyer
and I see a building with an 8 % cap rate in
a market where everything else is trading at
5%, I shouldn't just think, good deal. I should
be thinking, what's wrong with it? That's the
professional mindset. Your first thought shouldn't
be... wow, a bargain. It should be, what is the
market seeing that I am not? Is the tenant about
to leave? Is the building about to need a new
HVAC system? Is there new competition being built
across the street? That 8 % is a warning sign
as much as it is an invitation. So there's this
constant tug of war between these three things,
interest rates, growth, and risk. Always. And
the best investors are the ones who can correctly
identify which lever is pulling the hardest at
any given moment in the market cycle. Okay, now
we get to do some magic. Section five, valuation
and what you call the reverse math. This is what
appraisers and investors use to basically figure
out what a property is worth, right? It feels
like magic, but it's just a little bit of algebra.
This is called the direct capitalization approach
to valuation. So usually we have the formula
income value equal cap rate. But we can just
flip the equation around. Algebra is our friend
here. If we rearrange the terms, the formula
becomes value NOI cap rate. So if I know how
much money a building makes, and I know what
the market cap rate is for that type of building
in that location, I can tell you exactly what
it should sell for. You can get a very good estimate.
Try it with an example. Let's say you're looking
at a small apartment building, and you've determined
it produces $10 ,000 in NOI per year. Okay, small
building. $10 ,000 in income after expenses.
And you do your research, you look at recent
sales of similar buildings in the area, and you
see they're all selling at roughly a 7 % cap
rate. So I take my income, $10 ,000, and I divide
it by the market cap rate, .07. And what do you
get? Let me pull up a calculator. $10 ,000 divided
by .07 is $142 ,857. That is the estimated value
of your building. Simple as that. Now here is
where it gets really crazy. This is the value
-add strategy that every real estate guru on
the Internet talks about. Ah, yes. Let's say
I buy that building. I go in, I spend a little
money, I paint the walls, put in some nicer countertops,
and I'm able to raise the rents across the board.
Let's say I increase the NOI from $10 ,000 a
year to $12 ,000 a year, just a small $2 ,000
increase. Okay, a very achievable goal. Now run
the math again. All right, new NOI is $12 ,000.
The market cap rate is still 7%. So $12 ,000
divided by .07 is $171 ,428. So wait a minute.
You increase the annual income by only $2 ,000,
but you increase the value of the entire building
by... What's the difference there? Almost $30
,000. That is the multiplier effect. That's incredible.
It is. At a 7 % cap rate, every single dollar
of new income you add to the property creates
about $14 of value. If you were in a market with
a 5 % cap rate, every dollar of income creates
$20 of value. That explains why investors are
so obsessed with raising rents and cutting costs.
It's not just about the extra cash flow each
month. It's about this explosive effect on the
resale value of the asset. Exactly. Bye. Oh,
no. There's always a but. Multiplier works both
ways. Let's say you do nothing to the building.
Your income stays at $10 ,000, but the market
changes. The Fed raises rates. So just a moment
ago, your building was worth over $142 ,000.
Now it's worth $100 ,000. You just lost over
$40 ,000 in value, and the building's income
didn't change by a single penny. Whoa. That is
terrifying. Your net worth can get hammered by
market forces completely outside your control.
That is the power and the danger of the cap rate.
A small shift in that rate, just two or three
percentage points, can wipe out nearly 30 % of
your equity. This is why real estate cycles can
be so brutal. You can be running the building
perfectly, collecting all your rent, but if interest
rates rise or market sentiment sours, your asset
value can evaporate. That is a perfect, if terrifying,
segue to section six, historical trends and the
danger. Because we have seen this movie before.
We certainly have. Let's look at the data from
the Wall Street Journal that was mentioned in
our source stack. It's a classic case study.
The lead up to the 2007 -2008 crash. Exactly.
Between 2001 and 2007, we saw something unprecedented
in the commercial real estate market. The average
cap rate for office buildings in central business
districts dropped from about 10 % all the way
down to 5 .5%. A drop from 10 % to 5 .5%. That
means prices skyrocketed relative to the income
they were producing. Prices nearly doubled purely
on what we call cap rate compression. It was
a mania. Money was cheap. Optimism was high.
And people were paying more and more for the
same dollar of income. And there was one specific
deal that stands out as the poster child for
this whole era of mania. We have to talk about
the Stuyvesant Town deal. Stuyvesant Town and
Peter Cooper Village in New York City. This story
is legendary in real estate circles. It's the
ghost story investors tell their junior analysts
around the campfire. Set the scene for us. It's
2006. The market is absolutely frothy, and a
partnership of Tishman Spire and BlackRock decides
to buy this massive apartment complex in Manhattan.
We're talking 110 buildings, over 11 ,000 apartments.
The price tag was $5 .4 billion. At the time,
it was the single biggest real estate deal in
U .S. history. And when analysts ran the math
on what they paid versus the income the property
was generating at the time, the resulting cap
rate was, wait for it, 3 .1%. 3 .1%. I want you
to contextualize that for me. Why is a 3 .1 %
cap rate so unbelievably scary? Well, let's go
back to lever number one, the risk -free rate
we talked about. At that time in late 2006, you
could buy a 10 -year U .S. Treasury bond and
get a yield of about 4 .6 % or 4 .7%. Wait. Pause.
Let me make sure I understand this. I could lend
money to the United States government, a guaranteed
return, zero risk of default, and get nearly
5 % interest. Correct. But these incredibly smart
investors at Tishman Spire and BlackRock bought
a huge, complicated building full of toilets
and tenants for a 3 % return. That's a negative
risk premium. That makes absolutely zero sense
on the surface. On the surface, it's financial
madness. Why accept 3 % on a risky asset when
you can get almost 5 % on a risk -free one? higher
interest rate than the building was yielding,
they were guaranteed to lose money on every dollar
they borrowed from day one. So why on earth did
they do it? Were they just stupid? No, they were
incredibly ambitious. They were pulling the growth
lever we talked about earlier. They weren't buying
the property for that 3 % yield. They were betting
that the 3 % was a lie. What do you mean a lie?
They believed the income was artificially low.
A huge portion of Stuyvesant town was rent stabilized.
You had tenants who had been there for decades
paying 1980s prices for rent. The investor's
entire thesis was, we are going to go in, find
ways to get these people out, deregulate the
units, and bring all the rents up to the much
higher market rates. So they thought they could
aggressively double or triple the NOI in just
a few years. Exactly. They priced the deal not
on what it was, but on what they hoped it would
become. They paid for a perfect future. They
thought that 3 .1 percent yield would quickly
turn into a 10 percent or 12 percent yield through
that aggressive growth. And as we know from history,
that perfect future didn't materialize. Not even
close. The Tenants Association fought back tooth
and nail. The courts blocked their deregulation
plans. And then the knockout blow. The 2008 financial
crisis hit. The growth lever snapped off in their
hand. And because they had billions and billions
of dollars in debt. The negative leverage just
ate them alive. They defaulted, walked away,
handed the keys back to the lenders. Billions
of dollars in investor equity just vaporized.
It is the ultimate lesson in real estate. A low
cap rate is often disguised as safety, but it
can actually be a measure of speculative mania.
Wow. And then the rebound. What happened after
the crash, say, in late 2009? The fear lever
took over. Cap rates shot back up dramatically.
The data shows that office buildings in central
business districts went from that 5 .5 % low
back up to 8 .8%. Apartment buildings went back
up to 7 .36%. Prices fell faster than rents.
Much faster. The market was correcting. It was
resetting the risk premium to a more sane level.
Now, let's bring it to a more modern context.
We have data from a CBRE survey from early 2021.
This gives us a baseline for what normal looked
like before the recent inflation spike and rate
hikes. Right. In early 2021, multifamily housing
apartments were trading at cap rates between
3 .5 percent and 5 .0 percent. That's very low
again. High demand perceived as very safe. Extremely
high demand. People always need a place to live.
It's considered the most defensive asset class.
What about urban office buildings at that time?
They were in the range of 4 .5 % to 6 .5%. A
bit higher, a bit more risk with the rise of
remote work. And retail, malls and shopping centers.
That was trading from 5 .0 % to 7 .0%. Retail
is generally seen as riskier because of the Amazon
effect and changing shopping habits, so investors
demand a higher return to own it. It's fascinating
to see how the different asset classes stack
up, each with its own risk profile reflected
in its cap rate. You can read the entire story
of the economy just by looking at the spread
between those numbers. Okay, let's move into
the final stretch, Section 7, Advanced Concepts.
We're going to talk about reversionary value
and total return. This sounds like the graduate
level course. It is, but it's not as complicated
as it sounds. So far, we've mostly talked about
the current income, which in industry terms is
often called passing rent, what the tenants are
actually paying right now. Okay, passing rent.
But a professional valuer, an appraiser, also
looks at something called an ERV. ERV. Estimated
rental value. This is what the space could theoretically
rent for in the open market today if it were
vacant and you were signing a new lease. Ah,
okay. So if I have a tenant who signed a five
year lease four years ago and they're paying
$20 a square foot, but the market for new leases
is now $40 a square foot. Your passing rent is
$20, but your ERV is $40. The huge difference
between the two is the reversionary value. It's
the hidden locked in upside potential. When that
lease expires in one year. the value of that
income stream reverts to the much higher market
level. So a savvy investor might look at a building
with a low cap rate based on its current income,
knowing that the real cap rate based on ERV is
actually much higher. Exactly. They are hunting
for that spread. They look for a mark to market
opportunities. Conversely, if the passing rent
is equal to the ERV, the building is said to
be rack rented. Rack rented. That sounds painful.
It just means it's fully rented at current market
rates. There's no hidden upside in the leases.
What you see is what you get. Got it. And then
there's the idea of total return because the
cap rate is just the income part of the equation,
right? Right. The cap rate is like the dividend
from a stock. But we also care about the stock
price going up or down. We care about appreciation.
So how do you calculate total return? The simple
formula is total return, cap rate, plus the change
in the asset's value. So if I buy a building
at an 8 % cap rate, and over the year the building's
value goes up by 2%. Your total return for that
year is 10%, 8 plus 2. And if I buy it at an
8 % cap rate, and the market turns, the value
drops by 2%. Your total return is only 6%. Eight
minus two. You still got your income, but the
loss in value ate into your overall profit. And
using leverage, taking out a loan amplifies this
dramatically. Massively. We talk about LTV loan
to value. If you put 25 % down and borrow 75%,
a small 2 % increase in the building's value
can create an 8 % increase on your actual cash
equity. But a small 2 % decrease can create an
8 % loss. A double -edged sword. It cuts both
ways. Always. Just ask the owners of Stuyvesant
to. Right. Finally, let's wrap up with Section
8. Limitations and nuance. Is the cap rate a
perfect tool? No tool is ever perfect. The single
biggest flaw of the cap rate is that it is static.
It's a snapshot in time. Exactly. It looks at
a single year of income. It doesn't inherently
account for future rent growth or future capital
expenditures unless you adjust your expectations
for the rate itself. It assumes the status quo
continues forever. And real estate is inefficient,
right? It's not like the stock market where the
price is updated every second and is the same
for everyone. Correct. Real estate markets are
slow, opaque, and inefficient. Two different
appraisers can look at the same building and
come up with two different justifiable cap rates.
That's why sophisticated investors use multiple
valuation methods. They don't just rely on this
one number. Never. They use direct capitalization,
which is what we've been talking about. But they
also use market comparables, looking at the price
per square foot of similar physical buildings.
And they use replacement cost. How much would
it cost to build this exact building from scratch
today? You triangulate to find the truth. You
never trust just one number. Never. So after
all that, what does this all mean? Let's summarize
this journey. I think if we boil it all down,
the cap rate is the bridge. It's the link that
connects the physical asset, the bricks, the
glass, the land, to the world of finance and
financial return. It encapsulates everything
we talked about, risk, opportunity cost, and
growth expectations, all rolled into a single
elegant percentage. And for you, the listener,
the practical takeaway is this. Whether you are
looking at buying a small rental property, investing
in a big public REIT, or even just reading the
business section of the newspaper, look at the
cap rate. It tells you how the market feels about
that asset. Is it a safe, boring bet, a low cap?
Or is it a risky venture that could be a home
run or a strike out a high cap? It turns you
from a passive observer just looking at a price
tag into an active analyst. gives you a kind
of x -ray vision into the deal. It absolutely
does. I want to leave everyone with a final provocative
thought based on what we learned about Stuyvesant
Town and the nature of risk. Go for it. We tend
to think low numbers are safe. A 3 % cap rate
sounds safe and stable. It sounds like a government
bond. But if a cap rate is that low, it implies
the market is betting heavily, maybe desperately,
on future growth to justify the astronomical
price being paid. Correct. The price is baked
in a perfect future. But as we saw with that
deal, and as we're seeing in some markets today,
what happens when the future refuses to cooperate?
In a world of changing interest rates and economic
uncertainty, is that supposedly safe, low -cap
asset actually the riskiest bet of all? That
is the multi -billion, maybe multi -trillion
dollar question. When you pay for perfection,
you better hope you get perfection because there's
no margin for error. Exactly. Thank you for walking
us through the DNA of real estate value. My pleasure.
It was fun. And to our listeners, keep crunching
those numbers. We'll see you on the next deep
dive.