BiggerPockets

Once again , Mike is right....

If you use the 2% rule, and went with what most people put under the "Cap Rate" Section of the MLS , you'd need a 24% cap rate for the property.

Most commercial brokers will tell you, don't look at cap rates!

The way that large companies determine value of a property and returns is to look at the actual income vs expenses for the property.

If I figured out the return rate with all my rentals, on the cash invested portion , I'd be around 18% return or so, which is low becuase I've made PLENTY of mistakes this year due to learning the business.

1. Learn your market! Find out what the rental rates are (If you're looking at multi family).

2. Learn the going rents in your area! Next time you're out, grab a penny saver, then go to craigslist and fine out what properties are renting for.

3. Find out what the norm is in your area, and then work a plan to buy it at HALF of what everyone else does. This is the way WINNERS win the game, loosers buy at market value most of the time and proceed to loose their money.

If you could make $1000 a month, or loose $100 a month, which would you prefer? Many people seem to have it in their head it's better to loose $100 a month in the HOPE that the property appreciates. We've lost about 40% of real estate investors over the last 3 years from this GIMMICK of appreciation, yes, there is appreciation but you can't hedge your bets on it.

Hedge your bets on a good return (Leveraged returns using the 2%/50% rule should return 40%+ per year on a 25% LTV loan).

As Frank mentioned, Cap rates vary from city to city, and even from neighborhood to neighborhood. However, I certainly wouldn't say that cap rates are a big joke.

To utilize cap rates in your favor, you have to really understand cap rates and the market in which you wish to invest. That takes more than just leg work; it takes experience investing within a certain market. Therefore, if you come across a gem in Southern California selling at a 7% cap rate and you know the market is around 5.15%, you're looking at a deal right off the bat.

Of course, I'm not saying look at cap rates to evaluate a property. It's still all about expenses and income. Look for those poorly managed properties that you can turn around... and if you can get the property at a favorable cap rate, all the better.

Therefore, if you come across a gem in Southern California selling at a 7% cap rate and you know the market is around 5.15%, you're looking at a deal right off the bat.

I have some clients of mine looking at a 2006 built retail center in the Central Valley of CA, fully leased with NNN tenants on 4-20 year leases with a cap at 6%. This thing would've sold at about 4.5 - 5% a couple of years ago. Everyone around here is still asking 7-8% on retail centers, pro-forma of course.

That was my point, proforma = bs in my book.

Dustin,

Cap rates are one stochastic used by professional investors to compare one investment option against another...either in the same asset class or across classes.

After all how do you know if you if you should by a 4 unit rental property with your investment dollars or buy another unit across town...or better yet, put your money in another "type" of investment altogether.

The argument that one can never really "know" the expenses on his investments which then nullifies the value of cap rate calculation is patently ridiculous.

It's our job as investors to know all the costs associated with our investments to get the true ROR, and if that's a "tough" job during the due diliegence phase of buying a real estate investment...so be it. It still must be done.

That said, we then go forward to calculate the cap rate...an accurate number we can use for comparison.

In graduate school, one of the "givens" in multi-unit real estate analysis problems was the investors tax rate and their "anticipated rate of return"....or put another way...their opportunity cost rate. What I often referred to as the "I can do better over here" rate.

So once one did the cap rate, the pre-tax internal rate of return, and after tax internal rate of return...you could accurately decide if your investor should buy your RE investment or stick with his "better option over there".

BTW in terms of making investing decisions, the after-tax internal rate of return on real estate is the stochastic to use....not cap rates....it's just a better measure of what your really need to know...."Will I make money here?"

With all that said, the cap rate kicked around as "good" on mulit-unit residential rental properties...is between 10-12% per year. This is supposedly the thereshold where even stock market investors get interested in the real estate market.

BTW, every number you need (including expense figures) to determine if a property is a money maker is within reach, it only takes a little digging.

Don't listen to all the hyperbole here about what you "can't" do or what investors "never" do....you are an individual....and it's what YOU do that matters. :D

Good Luck!

Rob,
I feel for you. That post of yours is destin to get hammered by Mr Ohio.
At any rate, I agree with you. Internal rates of return are vital calculations in determining to move forward or walk away from an investment opp.
Cap rates are not usless, but there are just one of many calculations needed to making a decision on an investment.

This line is the best:
"Don't listen to all the hyperbole here about what you "can't" do or what investors "never" do....you are an individual....and it's what YOU do that matters."
EXACTLY!

For property comparison and pricing purposes a cap rate is a much better tool in my opinion. But positive cashflow must exist...

I used to wonder why anyone brought properties in California and New York with their low cap rates compared to markets like Ohio.

But over the past 10-20 years, you would most likely make more money buying and holding a property in Lower NY rather than buying and holding a property in, say, Cincinnati, OH. Here's one of many examples of property that a relative of mine purchased in Queens, NY:

Purchase Price: $360,000 (Year 2000)
Rents: $4,500 in 2000, Now $5,200 a month
Expenses approx $1,700 a month

The cap rate is low compared to that of a property in Ohio, but that property has appreciated to $800,000 today, and the in the Queens market, it can sell for close to $800,000 quickly.

The whole block has 5 of these houses built by the same developer in 1989. Each of the houses was built and sold for $100,000 in 1989. Someone brought their neighbors house in 2006 for $600,000, (same house basically) and just sold it for $800,000 last month.

Now I can't predict the future, I don't know if NY can still appreciate the way it has been for the past two decades. All I know is that a lot of millionaires were created (personally that I know) from buying and holding over a period of a few years.