This is the next installment in our monthly series on the portfolio of our retired author, R Paul Drake (“RPD”). This series is mainly targeted at our retired members to give them a retiree perspective on REIT investing. If you are not a retiree, you may still find value in this series as it often discusses many of our individual holdings.

Some Thoughts on Cap Rates

Much discussion of real estate investing revolves around cap rates. In energy investing a somewhat analogous concept is an EBITDA multiple (or its inverse).

The definition of a cap rate, as the ratio of NOI to Property Value, where NOI is Net Operating Income, seems straightforward. But there are ambiguities.

A simple one is whether one uses forward or trailing NOI. Another ambiguity is whether the cap rate is based on appraisals or on transactions. It is no surprise that transaction cap rates have exceeded appraisal cap rates during periods of economic stress. There are other ambiguities that we need not visit here.

What’s more, the cap rate tells you nothing about the state of the property or the context of the market. Here is a striking story from NCREIF:

It is important to remember the limitations of cap rates since they are just one piece of data in a complex world. I am going to borrow an example from a friend of mine. Her company bought two identical office buildings in a suburban office park. The buildings were completed a year apart, but were otherwise identical. When her company bought them they paid a 12% cap for one building and a 2% cap for the other.

The blended cap rate of 7% makes sense, but each building was very different. The first building delivered full at the peak of the market. Therefore when the existing leases were done, rents were likely to roll down and occupancy was likely to drop. Therefore, that building had a higher cap rate. The second building was finished during a recession and was never fully occupied. In addition, the rents were below market and likely to increase when the new leases were signed. Thus, they paid a low cap rate knowing that income would increase. This is a bit of an extreme example, but shows the danger of looking at just the cap rate. It is important to understand the factors that are driving the cap rate. Someone without knowledge of the situation may think the 12% cap rate was a steal and the 2% cap rate was overpriced.

That is a pretty extreme case, but we have seen commentary from Camden Property Trust (CPT) and other multifamily REITs to the effect that they often pay low cap rates for properties whose revenues can be quickly raised. So the headline cap rate gives you a wrong perspective about the business.

As to what causes cap rates, there is no question that (long, as in 10-year) Treasury rates have an influence. There is standard lore that says investors “demand” some return over Treasury Rates. This idea does not really stand up to history, though.

Here are the two curves for most of this century:

The spread was near 400 bps enough of the time that by the late teens this was often considered standard. Even today, one at times sees analysts claiming that this is the normal the markets will return to.

But what happened in the years from 2003 to 2007? Investors became convinced that real-estate values were headed ever upward and the spread collapsed. Oops. We get more information from this plot that covers 1991 to 2011:

Throughout the 1990s, the spread was never as large as 400 bps. You see the spread closing as 1990 approached. And it was negative throughout the 1980s. Think about that.

I haven’t come across US data for the 1970s. But I did communicate with one rates expert who noted that such spreads have very often been negative in less developed countries.

Perhaps when you can’t trust the local government to limit inflation, real estate income becomes more appealing than government debt? You decide whether that might happen again in the US.

My take is that cap rates and Treasury rates are set in different markets and subject to different influences. Evidence for this is that the spread between them has varied so much in the history. And while it would seem that cap rates should exceed Treasury rates, even that has not always been true.

On top of that, for quality REITs specifically, interest expenses are not so dominant that the cap rate-Treasury spread is of central importance. Cap rates matter a lot; Treasury rates much less.

This is part of why I trust and value cash flows above other measures. Still, though, no single number tells the story.

The following contains updates throughout; much of it is a repeat of my last monthly update.

My Context

My secure income covers 2/3 of my spending budget. At the moment, the other third comes from various paid work.

The secure income includes social security, a pension, and a collection of annuities. Nearly all those sources have escalators of either 2% or inflation.

My dividends from “Go-Fishing” positions — very secure firms likely to grow dividends at least with inflation — also could cover more than a third of my spending. So if work stopped or when it stops, current spending is covered without drawing down the portfolio.

In the meantime I will use those dividends to grow the portfolio and to provide early legacy spending. That will include some early inheritance funds to the kids each year.

The rest of the portfolio pays additional dividends (though not from all positions). These also will help grow the portfolio.

My portfolio today includes four buckets.

1. There is an income bucket, which includes mainly “Go-Fishing” stocks. These are from firms that only need monitoring once a year, if that.

2. There is a “medium-risk” bucket, pursuing gains and income from market mispricing of blue-chips or other quality companies and holding high-yield positions for which I have concerns about the dividend.

3. There is an upside bucket, holding small, speculative positions for which I see the potential of gains of 50% or more.

4. There is an illiquid bucket of long-term, private investments made years ago. It stands at 13%.

5. Most often I hold little cash. But at the moment I have 6.1% in cash. This is discussed further below.

Dividends are the goal but we also know that chasing yield is a losing game. And we know that growth of portfolio market value can be a path to affording larger total dividends.

Update on My Portfolio and Trades