Why I don’t talk about cap rates


About 10 times a week, people ask me what kind of cap rates I expect from our deals. In my answers, I strongly resist using the term cap rate, to the point that people think I’m a little strange.

This is kind of weird, right? Any book you read about investment property is going to go on and on about “cap rate”. So, why don’t I use the expression?

To understand why, you first need to know what it means. “Cap rate” is short for “capitalization rate”. It refers to the annual return, in cash, that an owner can expect to receive by buying a property at a given price WITHOUT a mortgage. You calculate the cap rate by taking the expected net operating income and dividing it by the purchase price.

Notice that the concept is essentially passive: You’re buying a building with NOI in place, for a given price.

For my deals, neither of these is true. I almost always vacate all units ASAP after closing on an apartment building. So, right away, there is no revenue coming in and, therefore, the net operating income is negative (because we still have to pay holding costs, like property tax and insurance, while the renovations are on-going). The net operating income only turns positive after we re-tenant, which is 6-12 months after the project begins.

And, the purchase price is also kind of irrelevant, because we’re going to spend so much money renovating the building. For a typical deal, the purchase price might represent something like 70-80% of the total capitalization of the project. And that’s just the money spent; it does not reflect the ridiculous amount of expertise and effort that goes into transforming a beat up old POS building into a desirable place to live.

What we do is NOT passive; it’s the opposite. You can think of it like this: (new annual revenue – new annual operating expenses)/(acquisition price + rehab cost + holding costs) = “unlevered yield”.

So, that is the expression I use for what we can get: “unlevered yield”.

(In case you’re wondering: Because we do this better than anyone, we can still find deals where the unlevered yield is >8%.)