Cap Rates Don’t Tell You Risk — Variability Does

Two properties can have identical cap rates—and completely different risk profiles. In this episode, we unpack why cap rate is simply a snapshot of performance, not a measure of stability or safety. By looking beyond the headline number and into how income actually behaves over time, we explore how operating margin consistency and expense ratio variability shape the real risk of a deal. Through clear examples, you’ll see how two “8 cap” properties can produce entirely different ownership experiences—one predictable and resilient, the other volatile and stressful.

We also dive into the practical implications of variability: how swings in expenses and NOI impact cash flow, debt coverage, and the likelihood of capital calls. This episode reframes how to evaluate deals by focusing on what actually drives outcomes—stability, not just yield. If you’ve ever relied on cap rate as a primary decision-making tool, this conversation will challenge that thinking and give you a more grounded, reality-based framework for assessing risk in real estate investments.

Beacon Hill Property Advisors - https://bhpropertyadvisors.com/

Transcript

SPEAKER_00 0:12

Welcome to Beyond IRR. This podcast examines real estate investments through the lens of structure, risk, and capital durability, not just headline returns. I'm your host, Louis Heiza. This podcast is sponsored by Beacon Hill Property Advisors. Cap rates are one of the most widely used metrics in real estate investing and also one of the most misunderstood. On the surface, they feel incredibly useful. You take NOI, divide it by the purchase price, and you get a clean, simple percentage that tells you how quote unquote good a deal is. An eight cap sounds better than a six cap, a ten cap sounds even better. But here's the problem. Cap rates tell you nothing about how that income behaves. And in real estate, how income behaves is the equivalent of risk. Let's start with a simple thought experiment. So imagine two properties. Both are priced at a million dollars. Both generate, let's say, $80,000 in NOI. That's an 8% cap rate. On paper, identical deals. But now let's look under the hood. Property A, let's categorize this as 98% occupancy, stable tenant base, expense ratio, let's say 35%, minimal deferred maintenance, predictable rent collections, low delinquency. The monthly NOI barely moves. It might fluctuate a few percent, but it's consistent. Property B, on the other hand, let's say the occupancy swings between 88 and 95%. You have higher tenant turnover. That expense ratio is 5%. There's frequent repairs and maintenance surprises, and occasional delinquency spikes. The monthly NOI is all over the place. Some months look great, others are borderline breakeven. It's the same cap rate though, but it's a completely different risk profile. So that's the core idea here. Cap rate is a snapshot. Risk is a time series, and if you don't look at variability, you're blind to the actual behavior of the investment. So why does a cap rate fail as a risk metric? Cap rates assume stability. It assumes that the NOI you're using is repeatable, predictable, and durable. But in reality, NOI is a distribution, it's not a fixed number. It fluctuates based on occupancy, expenses, tenant quality, seasonality, operational execution. So when you compress all of that into a single number, you lose the most important information, how fragile that income stream is. So here's an example of the illusion of a good deal. So let's say you buy property B in our above scenario because it's an eight cap, while similar assets are trading at seven caps. You think you're getting a better deal. But over the first year, two major HVAC systems fail. Delinquency spikes during the winter. Occupancy drops to 88% for three months. Your NOI doesn't come out come out to, in this case, $80,000. What if it comes in at $60,000? Suddenly, your eight cap is actually a six cap, but more importantly, it's volatile, and that volatility is what creates stress. A couple years ago, I bought a like a 110-year-old five-story mixed-use building that perfectly describes this. It was early on in my investing career, and on paper, it cash-flowed like a champion. What I failed to realize was that older buildings, in this case, unless they're meticulously maintained, and this one was absolutely not, will have deferred maintenance and therefore higher expense ratios, and it will have surprise capex. Especially if you're a younger investor, your due diligence is not quite up to par, and you miss some of the bigger items, or just look past it, that 20-year-old flat roof that you said, eh, we don't really have the budget to replace it. But uh, you know, why would it fail? Hasn't failed yet. We're only gonna hold this deal for five years. Let's just ignore it. And when these issues occur repeatedly, that's gonna affect occupancy. Tenants are gonna be mad when their heat goes out in the middle of winter and the roof keeps leaking and you don't have the budget. So all of a sudden, not only do you have spiking maintenance in CapEx, your revenue can decrease because of occupancy. So luckily in this case, we bought this building cheap enough that we had room to refinance, pull cash out to dump into CapEx, and stabilize the expense ratio and the CapEx shocks, but had we not had that room to refinance, we would have been in a very bad position. So the real risk is variability. Risk in real estate is not just will I lose money, it's will I miss a debt payment? Will I need to inject capital? Will returns be inconsistent? Will the property behave unpredictably? All of those questions are not answered by a cap rate, but by variability. One of the most powerful ways to understand this is through operating margin stability. Operating margin is calculated by NOI divided by revenue. It's just one minus expense ratio. The key is not the number itself, it's how much the margin fluctuates over time. So let's look at two more deals. Property A, revenue, say $200,000, expenses $70,000, NOI $130, therefore. That margin is 65%. That means that's an expense ratio of 35%. So month to month, let's say it moves between 63 and 67, the um, the operating margin. So that's a very tight range, very predictable. Property B, on the other hand, let's say it's the same $200,000 revenue, except this time the expenses will be $110,000. So that's an NOI of 90K. That margin's 45% or an expense ratio of 55%. But month to month, let's say one month it's 55%, then then it's down to 35. This is operating margin, and then it's backed up to 50. It's huge swings. And that variability is risk because every dip brings you closer to DSCR pressure, cash flow interruptions, capital calls. So now let's zoom in on what's often driving that instability. That's the expense ratio. So expense ratio, it's the opposite, or it's one minus or the inverse of the operating margin. It's operating expenses divided by revenue. So this is one of the most underrated metrics in real estate because expenses are where unpredictability lives. Stable expense profile, let's take a look at one property A. You have professional management, preventative maintenance, predictable utilities, long-term vendor contracts. That expense ratio is probably going to hover around that 35%. The volatile expense profile, property B, reactive maintenance, deferred capex, emergency repairs, poor tenant care. Your expense ratio is going to swing between 45% and 65%. And here's the key insight: revenue tends to be relatively stable. Expenses are where the chaos happens. And as not only an investor myself, but as someone who runs a property management company, boots on the ground property management, I can tell you that's absolutely true. Revenue does tend to be relatively stable. Occupancy and delinquency are pretty consistent just statistics. And the more properties you have, or the more units you have, the more stable that's going to be. Now, of course, you can get better revenue, you can be better at your marketing, you can make sure you're not overpricing your units to decrease vacancy, but it's expenses where the chaos actually happens. So when expense ratios are unstable, your entire investment becomes unstable. So here's a real life example to illustrate this point. So let's say you own a 20-unit multifamily building. Each unit rents for $1,000. So that's $20,000 per month in gross potential rent. So let's look at two scenarios here. So scenario one is gonna be the stable operations. We've got 95% occupancy, so that's $19,000 collected per month. Expenses, let's say seven grand. So that's an NOI of $12,000. The next month, let's say occupancy ticks up 96%. So now we're at revenue $19,200. Expenses, let's say they tick up two. That's often the case, that you have a little more expenses when uh properties fill up. You know, you might have a little more repairs and maintenance because you have a new tenant submitting work orders, et cetera. So let's say expenses are $7,200. Therefore, the NOI again is $1,200. So this is an example of a very stable type operation where things are fluctuating a little, but they're very in a tight, a very tight margin. Therefore, your NOI is stable. Now let's go to scenario two. This is gonna be the volatile operation. Let's say month one, we've got 92% occupancy. So that's $18,400. Let's say the expenses spike because of some repairs, $9,500 expenses. So that's an NOI of $8,900. Month two, let's say occupancy ticks up 95%. We're back up to that $19,000 uh collections for the month. And expenses, let's say they drop to seven. That's an NOI of $12,000 again. Okay, looks pretty good. Month three, however, let's say occupancy drops 90%. That's $18,000 in revenue. Let's say there's a spike in expenses, $10,000, that's an NOI of $8,000. So we're swinging between $8,000 and $12,000. That's significant swings. These are the same size properties, the same nominal rents, but wildly different experiences as an owner. And as a result, you have wild swings of expense ratio and maybe more importantly, DSCR. And that can swing potentially below one. That means you're dipping into reserves or your pocket to make mortgage patents. So let's ask the question: why does this matter for debt? This obviously becomes even more critical when leverage is involved, especially higher leverage. Let's say your monthly debt service is $9,500. So property A, we had that NOI of about $12,000 per month. That's a pretty consistent DSCR of $1.26. That's very safe. Banks like $1.26. Again, banks are typically around 1.2 to $1.25. I see them make exceptions for below $1.2, but they have to make exceptions. They don't want to do that. So you shouldn't want to do that either. Property B, we had those NOI swings between $12,000 and $8,000. $12,000, again, that's DSCR 1.26, looks great. 8,000 NOI, that's a DSCR of 0.84. You're underwater for some months. And that's not just a lower return. That's default risk, unless you're willing to come out of pocket and have the ability to come out of pocket to cover that mortgage payment. So here is the punchline. Cap rates tell you what the deal looks like if everything goes right and stays stable. Variability tells you what happens when reality shows up. So at Beacon Hill, we treat metrics as causal and layered. Cap rate lives in the summary world. And to a technical point here, investors really only refer to cap rates when analyzing a future deal or selling a property. So in the context of ongoing performance analysis, the exact same mathematical formula of being NOI divided by value or price, we actually refer to that as the free and clear rate of return. It's essentially ROI if there was no debt, because NOI should be your bottom, isn't very nearly your bottom line on a PL. Um, that's not exactly true because you do need to take into account other business expenses that sit below the NOI on a PL. When calculating ROI, for example, such as tax preparation, software expenses, really any expenses that are not the property's fault, but rather the investor's fault. Therefore, they sit below NOI. But these tend to be minimal when compared to overall expenses. So if you ever hear someone talk about a free and clear rate of return, it's it's a cap rate. It's the same math. But going back to risk, we find that it lives in cash flow volatility, worst month performance, expense ratio behavior, operating or expense ratio stability. And those are the metrics we like to track at the top of our dashboards. So instead of asking what's the cap rate, we ask how often does NOI drop below break-even? What's the worst case month? How sensitive is NOI to small changes in occupancy or expenses? How stable is the operating margin over time? So now let's examine a better way to compare deals. So going back to original two properties, instead of just comparing cap rates, let's compare expense ratio. Property A was uh 35% expense ratio. That's stable. That's about where you where you want to live for a multifamily. Set our we set our thresholds uh on our KPI dashboards uh for a multifamily property. It's gonna be between 35 and 40. Um, that'll be our thresholds. In between, those will be colored yellow. Anything above 40 is gonna be red. Anything below 35 is you're in the green. That's that's a great uh expense ratio. Property B for more examples is a 55%. That's volatile. And we get those generic labels, by the way, of stable and volatile uh from metrics such as cash flow volatility or downside months. We can actually calculate and have an uh explicit number to refer to that translates into the words stable or volatile. Let's look at NOI volatility for these two properties. Uh property A was plus or minus 3%. That's very tight. Property B plus or minus 25%. Worst month NOI. Property A, if you annualize the worst month, uh you're looking at $75,000 in NOI per year. Property B was $50,000. ESCR range, again, property A, we were between 1.2 and 1.3. Banks are fine with that. Even on the worst month, 1.2 is okay, most likely, depending on your lender. Property B was between 0.8 and 1.3. You're underwater uh many of the months or some of the months. So the difference is now very, very obvious. You could consider one an investment and the other as a gamble. Some people might argue that that that's not maybe the case, that they're both investments. But the point being, an investment is truly categorized as an allocation of capital with expected periodic payments. Certainly in real estate, that's an expectation, is a periodic payments. If you can't expect periodic payments because you're doing your proformas correctly, and a property showing that it's probably going to be volatile due to, you know, deferred maintenance, whatever, then I don't know, is that an investment? So another example uh to really highlight this point is gonna be the value add trap. This shows a lot, shows up a lot in value add deals. So a property might be marketed as, you know, eight and a half cap, strong upside, operational inefficiencies. So what that really means, you know, translate that into analysis talk, high expense ratios, poor maintenance, tenant instability. So yes, the cap rate does look attractive, but the current operations are chaotic. And if you don't stabilize operations quickly, you inherit high variability, cash flow swings, execution risk, and that risk is not priced into the cap rate. So here is the big insight from this entire discussion: is cap rate measures snapshot operating margin compared to value? Variability measures risk. And if you only look at cap rates, you're missing half the picture. You're missing the scary half, which is the risk. So here's some practical takeaways. When evaluating a deal, start asking how stable is the expense ratio over time? What does monthly NOI look like and not just annual? What's the worst performing month? How often does performance dip below expectations? What drives variability, expenses, occupancy, or both? Because two deals can look identical on paper, but behave completely differently in reality. And in real estate, behavior is everything. We'll close here with a fun fact regarding cap rates. So in finance, there's a concept called volatility drag, where two investments with the same average return can produce very different outcomes depending on how they fluctuate. Real estate works the same way. Two properties with the same average NOI or cap rate can produce dramatically different long-term results purely because one is stable and the other is volatile. And once you see that, it's really hard to look at cap rates the same way again. Hope you got a lot out of this episode and stay tuned for the next one. Thank you for listening to Beyond IRR. This podcast is produced by Beacon Hill Property Advisors, where we focus on bringing clarity, structure, and rigor to real estate investment analysis. If you want to evaluate deals beyond headline metrics and better understand the mechanics driving performance, you can learn more about our tools and approach at bhpropertyadvisors.com. You can also connect with us directly for demonstrations, resources, and additional insights. Until next time, analyze deeply, allocate wisely, and always go beyond IRR