Battle of the Cap Rates

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Want higher ones, right? I don’t.

Confused? I don’t blame you. You heard me right. I am just recently more impressed with 7-10% cap rates than 12%+ cap rates. I’ve had just enough experience in the rental property world to teach me that there is some real value in not ruling out those lower cap rates!

What is a Cap Rate?

A cap rate is a measure of the purchase price of an investment property compared to the net income you make from that property. If you pay all cash for a property, it’s the measure of how much you make on the property compared to how much money you put in, which is the same as your cash-on-cash return. If you finance a property, your cap rate is different than your cash-on-cash return. Cap rates are the general calculation done on most investment properties to give the buyer an idea of how good the investment may be, so for now, I’m sticking with those.

The Cap Rate equation:

Annual NET Income / Purchase Price = Cap Rate

Today’s Rental Market

It’s hard to say what a good cap rate is. In general, I would say anything over a 6% cap rate is potentially a good investment (I say potentially because there are of course other factors involved). This goes for residential or commercial, big or small.

For single-family homes and duplexes today, with the market where it is, my observation is that rental properties are ranging from 6% caps to upwards of 20%. Of that range, I would say 6-15% is with more expensive homes or turnkey rentals. Higher than 15% and you are most likely dealing with fixer-uppers. For the purposes of this article, I’m going to stay focused on the turnkey rentals since those are what I deal with personally, plus it keeps things more simple because going into how rehabbing affects returns is more complicated than the point I am trying to make. So I’m going to address the 6% to 15% Cap Rate range.

Higher or Lower Cap Rate?

Various factors go into what makes a good investment property. What condition the house is in, what area it is in, the kind of tenants most likely to move into it, your exit strategy, and the list goes on.  As I continue to work around rental properties, I’m noticing more and more the patterns between purchase price, cap rates, and quality. The cap rates in various markets are starting to merge due to the upswing of the general real estate economy (in my opinion), but there are still fairly clear distinctions between what markets can give you what cap rates. If someone tells me they want the highest cap rate possible, I steer them to one market. If they are more concerned with quality and appreciation potential, I steer them to another market. Every once in a while there is a market that has a great combo of all things awesome- high cap rates, high quality, and high appreciation potential. For example, Phoenix about three years ago and Atlanta about a year ago. There is a reason why the institutional funds and investors flooded those markets! Outside of those rockstar markets though, there is a lot more distinction between your options.

With some exceptions, here are my general observations between the higher and lower cap rates in turnkey world, so the difference between 6% and 15% (and these are very generic assumptions and vary between the markets):

  • High Cap Rates (15%). Purchase price ranges $30k-50k. Fully rehabbed, but older properties probably early 1990s or older, if not 1970s and older. Not in bad areas necessarily, but definitely not fabulous. Areas with more renters than owner-occupants. Appreciation potential is only mediocre to minimal over any general economy appreciation.
  • Middle of the Road Cap Rates (8-11%). Purchase price ranges $60k-100k. Houses are probably late 1980s-mid 2000s in age. Not horribly small houses, nothing gigantic. Still probably in more renter-heavy neighborhoods but more solid on tenant quality. Appreciation potential is probably in line with the general economic upswing.
  • Low Cap Rates (6-7%). Purchase price ranges $100k+. Much newer houses. In markets that are much more heavily owner-occupied than renter-heavy, more “popular” or “sexy” markets, and possibly markets that aren’t really considered to be as investor-advantaged because of the price-to-rent ratios, but people still want to own there.

I feel compelled to emphasize again, these are extreme generalizations and there are exceptions to all of these.

Which Cap Rate to Choose

At the end of the day, deciding what investment property to go with ultimately depends on your preferences. What do you want to accomplish, and what are you most comfortable with?  A lot of people aren’t comfortable investing in areas that produce the higher cap rates and consequently they will invest in a market solely because it is that market and returns are second to that. One example is Phoenix. Right now, turnkey rentals are giving about a 0-3% cap rate there. Believe it or not, they are still selling! The people buying there now are set on owning in Phoenix and the minimal returns don’t matter. On the flip side, some investors only care about cap rates. Opposite of Phoenix, Detroit can give extremely high cap rates and if cap rates are all someone cares about, there you go! Never mind the market quality or who would ever want to live there.

I used to shoot for the highest cap rates I could find the in the areas I liked best. I never sacrificed total quality to get that high of a cap rate, but I was definitely more inclined to stay on the higher side. Since then, however, I have learned a lot about the returns shown on paper and the real-life returns. More specifically, long-term returns.

Right now, if I were to decide to buy another property, market of my choice, property type and style of my choice, I would choose the $80k-180k price range with 6-10% cap rates. All day long, no question. Here’s why:

  • Tenant Quality. Tenant quality is what matters for an investment. If you have bad tenants, you will lose your hind side. No question about it. Evictions cost money. Vacancies cost more money. Repairs are never-ending. While this won’t be the case for every sub-$30k property, which is where you are going to see those really high published cap rates, who exactly do you think is moving into a house worth less than $30k? It’s most likely not the most upstanding citizen! Anyone with any sense of responsibility and care is most likely in a position to rent a nicer place in a nicer area. Maybe not even that nice, but not sub-$30k.
  • Property Condition. Houses deteriorate, and when they do, they get expensive! All houses will need work, there’s no way around it, but the difference between a sub-$30k house and a $100k house is likely to be in the tens of thousands of dollars, if not more. Money aside, hello stress. I don’t want to worry about maintenance. Every time I hear something broke in one of my properties, I cringe. I prefer to have as few of those calls as possible.
  • Appreciation Potential. I will never buy a property solely banking on appreciation, but let’s be honest, if I can get some appreciation, I’ll take it! Sub-$30k properties are doubtfully going to appreciate by much (not including flipping properties). Owner-occupied style houses in nice areas, however, by far have the best potential for increasing value. The advantage to the appreciation is my ability to use that new equity to roll into other investments!

All of this comes down to the long-term returns of a property. If you have an old house with not the best tenants, you are going to pay a fortune in vacancies and repairs. With that said, if you account for these when you are analyzing the property, then there’s no harm done.

How to Calculate an Accurate Cap Rate

Most investors are good at calculating all of the known expenses for a property- insurance, property taxes, property management (if applicable), and HOA (if applicable). What a lot of investors don’t do, however, is calculate in vacancies and repairs. Obviously there is no way to know this number for sure, but you can certainly make an educated guess.

For my turnkey rentals, I usually estimate 7% of the monthly rent for vacancies and 5% for repairs. The vacancy allocation is really just an average and I could tweak that more accurately if I look up vacancy rates in the area I’m buying in and talk to the property managers and see what the going rate is. The repairs on the turnkeys are typically very minimal to start because they are newly rehabbed properties so likely don’t have a lot of work needing to be done right away. Remember too though, just because a property doesn’t need a lot of work in the first year or two, repairs will start coming, so be conservative with your estimates initially to account for the back-end.

As soon as you get into cheaper properties, i.e. higher cap rates, you are very likely going to see higher vacancies because of tenant quality and more repairs because the properties are older. I wouldn’t put it past a property to need to be estimated at 20% vacancy and 25% repairs. You think I’m exaggerating, I’m absolutely not. That could even be on the low-end for some properties. If this is the property type you are dealing with, fine so be it, but make sure to estimate the realistic vacancy and repairs from the start. If the guy with the megaphone is shouting “20% cap rates, come and get ‘em!!” and the property was built in 1972 and in a fairly low-income area, I’d almost bet he has left out vacancy and repairs estimates, but even if he has included them but only used the 7% and 5% estimates rather than the 20% and 25% estimates, he’s totally off with his 20% claim.

Vacancies and repairs will tank your investment!

Be sure to account for them appropriately. And seriously, don’t kid yourself and swear they won’t be that bad. I have nice properties in nicer neighborhoods and I’ve lost out numerous times due to both of those! In those cases, it was more property management related, but the fact remains, bad tenants and property quality and your investment tanks.

For me, as a more seasoned investor now, I am so much more willing to look at 7% cap rate properties than I ever was before because the returns over the long-run and the decrease in stress make my investment so much more worth it, both in monetary returns and sanity.  I don’t expect everyone to agree with me, and a lot of investors enjoy the challenge of doing a lot of the work themselves and managing tenants, but for the hands-off investor like myself, nice houses and good tenants are the way to go. As always, there will always be exceptions to every rule and not every expensive property with a low cap rate will be flawless, but the risk is significantly less than with the cheaper “higher cap rate” (I use that term loosely) properties, and even if a tenant flops, you have a better chance of fixing the problem with the next tenant. Think about it- one bad roof on a property and what does that do to your returns that year? Especially if your tenants are only paying $500/month!

In case you haven’t completely followed what I’m trying to say, the moral of the story is- I would buy a $120k property with a 6% cap rate any day over a $40k property with an 18% cap rate. I guarantee it is a rare occasion that the $40k property will actually see that 18%. Even if it does, there will probably be so much stress with it that again, I have no desire.

What is your experience? Anyone invested on both sides of the cap rate spectrum?

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About Author

Ali Boone(G+) recently left her corporate job as an Aeronautical Engineer to work full-time in Real Estate Investing. She began as an investor only two years ago but managed to buy 5 properties in just 18 months using only creative financing methods. Her focuses have been on rental properties and overseas investing in Nicaragua.

35 Comments

  1. @Ali Boone An excellent article, Ali. In fact it should be required reading for every newly-minted investor.

    You’re quite right to warn against being dazzled by a property with a high cap rate. High reward typically implies high risk. A property that projects a 12%, 15%, 18% cap rate may seem like a great deal (wow, you mean I’m gonna get an 18% return?), but the back story may very well include a dicey location, mountains of deferred maintenance, collection problems, chronic vacancies, and tenants you might wish you never had. Properties with lower cap rates may be more expensive (and thus promise a lower return), but the likelihood of actually receiving that return, without drama, may be considerably greater.

    Great job.

    • Thanks, Frank. I appreciate the compliment and I totally agree. I’ve had the personal experience of chronic vacancies and bad tenants and it totally blows your whole investment.

  2. For commercial investment, cap rate is higher, if mortgage interest is higher. Same, cap rate is low, if rates are lower. This applies to financing investment as well as for 100 % down.

    • @Kris, If I understand your comment correctly, you’re speaking about the effect of market-wide mortgage rates, generally, affecting market cap rates (not about the mortgage rate on an individual property affecting its individual cap rate).

      If so, then yes, I believe your observation true. You can see that when you look at an alternative cap rate approach, “band of investment,” which is a weighted average of the investor’s required return and the lender’s required return (the mortgage constant). The higher the mortgage constant, the higher this blended rate. In other words, more expensive financing tends to put a downward push on prices.

      Sidebar: For what it’s worth, in my experience, this blended rate usually doesn’t usually vary all that much from the market cap rate. I believe this to be so because I think the market recognizes the prevailing lending environment and that gets built in to the market-driven cap rate.

    • Hi Kris, yes you are correct but your statement is more for calculating the cash-on-cash return. Cap rates don’t typically include the cost of financing, but the cash-on-cash (which is actually a more important calculation in my opinion) definitely does.

  3. Good stuff Ali! If I could add a few things,

    In my experiance a bit more focused definition of a CAP Rate would be that it is the rate of return that the average investor would accept on a particular type of property in a given location.

    I must disagree with you Ali as to the notion that it is hard to know what a “good” cape rate is. It is easy to know what it is. The market at large, that is to say all of the investors collectively operating in that marketplace, vote on what the CAP rate should be for a particular type of building in this marketplace with how much they pay! If your deal is under this number, then you are not getting as good of a deal as the collective majority of the participants in this marketplace.

    Here is the problem: the only expense not included into the CAP Rate is the cost of money. This means that if your CAP is too low, chances are so will be your cash flow if we assume similar cost of money for all participants in a given marketplace, which is the real issue in all this…

    For instance, I will not seriously consider anything under 10 CAP – period, and I will only look at a 10 CAP if there are significant expandability options which can get me to 12 CAP over time, which is where I want to be.

    This is possible in Ohio, however, this may not be possibly in Seattle Washington. However, our goal should always be to beat the CAP set by the marketplace!

    Thanks Ali

    • Hey Ben, good comments . You are right about knowing what a good cap rate is in terms of a market. I think you are totally on about making sure you are getting a good rate for what that market can offer at that time. I think when I said it I was talking more about varying across markets. Like Indy can give a 12% cap right now and Dallas can only give a 7%. Is the Dallas 7% bad? Depends on what you want and what you are comfortable with. But yes, I agree, make sure you are getting a good cap for the market.

      With that said, I’d caution investors to not try so hard to beat the going cap rate that they dump money into a quirky property that may cause problems later.

  4. Ali, your assumptions are pretty good. It took me years of hard work to learn that one can go after cash flow or appreciation, rarely both. Started out with cash flowing cheap rentals, learn the tenants weren’t much different. Later bought REOs in nice neighborhoods and did a lot better. My CAPs are pretty high because of the way I purchase property and rehab them adding value.

    I only look at a few things when purchasing a property: price to value, condition, can I add value, type of neighborhood and positive monthly cash flow. A great realtor and property manager will dissolve most headaches and uncertainties.

    I don’t usually say this, but for those starting out should memorize your post, a very good plan of action. The best returns come from buying in populated areas with lots of diverse employment that has mostly family owned homes. Buy where everyone else is buying, just buy better.

    • Wow, thanks Jim for saying people should memorize my post. I can’t think of a better compliment.

      I totally agree with exactly what you say. High cap rates upfront, in my opinion, rarely remain high cap rates in the long-run. I plan to invest in the areas you mention as well, with lower cap rates. I’m not a fan of headaches.

  5. @Ben Leybovich raises a very good point here, and explained it very well. Cap rates are essentially a market-driven metric — a market cap rate represents the rate of return that investors in a particular location are actually achieving with a certain property type (office retail, etc.). As such, you really can’t describe a rate as being high or low universally. A 9% cap rate on a particular property might seem very high to an investor in midtown Manhattan, while the same rate could seem very low to someone in Upper Dry-Rot County.

    I don’t want to invent any new terminology (we have enough already) but perhaps a way to wrap your mind around this is to start by recognizing that the market cap rate is, as I said, the rate of return other investors are actually achieving for a given property type in this location. Then, when looking at a particular property, calculate its cap rate and ask, “Is this property yielding a market cap rate, an above-market rate or a below-market rate?” I think describing a property as being above or below the market rate will tell you more than describing it as having a high or a low rate.

    • I totally agree Frank. I think Ben nailed a very valid point I didn’t think of and everyone should consider the market going rate, for sure. That’s even good advice for myself!

  6. Thanks for article. Newbie question: How do you factor in principle pay down and how to you amortize loans when looking at cap rates or cash flow on rentals? I mean a 15 yr note might have worse cash flow than a 30 but better principle pay down?

    Also, do multi-units play by the same general rules in this article as SFH’s?

    • @Terry P Cap Rate = Net Operating Income / Value Since NOI is before debt service, the financing doesn’t enter into the standard cap rate calculation.

      Cash flow is NOI less debt service and other non-operating costs such as capital expenditures. Hence, the debt service does affect the cash flow calculation. The extent to which the principal portion is greater or lesser doesn’t change the cash flow calculation except, of course, that the larger payment with a shorter term will leave you with less immediate cash flow than the smaller payment/longer term.

      I would do a 5- to 10-year pro forma that included the eventual sale of the property. An IRR calculation would help you test the effect of a number of variables, including the effects of different financing scenarios.

    • CAP rate metric is used to peg a value to a piece of income-producing real estate based on its’ income as represented in the NOI. It is used exclusively in the multi-family commercial and industrial spaces. The value-setting mechanism in the SFR space is a function of the comparative market approach and not the income. Trying to utilize CAP rate analysis in the single family space is highly misleading and impractical. Hope this helps :)

      • Hi Ben, I actually disagree with you on this one. I do see where you are coming from because typically SFRs are set based on market value, but I think more popularly right now, at least in turnkey world for sure, the prices are most definitely being set based on the income. Most of the properties I work with are sold at prices that give the investor a particular market-standard cap rate. I don’t think using cap rates on SFRs is misleading at all, because even if the property is sold based on market value rather than income, the cap rate still gives you an idea of what kind of deal you are getting based on the income.

    • Hey Terry, great question. I think Frank nailed out a better answer than I could have so I’m voting to stick with his response :) Hope that helps.

  7. Great post Ali and worthy reading for someone starting out. The biggest point you actually make..from your own experience and my own…..is the true cost of vacancy, vandalism and repairs. These items turn that pro-forma on a “rent-ready” investment into toilet paper…in fact, a roll of paper might end being worth more than the investment. To me, CAP rates are just one of many ways of measuring the potential performance of different properties. You still have to use your head and most importantly, only buy where you have people boots on the ground to run the property. I’m in metro Atlanta, a pretty hot market by most measures…..and I get calls everyday from investors who have sat on an empty property for at least a year or more.

    Enjoyed the post…happy investing!

  8. I’ve got several properties for sale with 9% cap rate and UP and I am looking for some help with finding the investors…is there a blog / forum / group where I can connect with “buy & hold” investors in the Los Angeles area?

    • You could definitely create a post in the forums…say something in the title about ‘looking for los angeles investors’ or something like that. Use keywords so it alerts people of your post. There are tons of investors out there.

      Where are the properties you are talking about?

  9. Ali,

    Great read! I’ve been wanting to learn more about Cap Rates and you helped explain exactly what I wanted to know about it. I now feel more comfortable plugging in a chosen percentage for my calculations, instead of just throwing numbers around and only knowing that I didn’t want something too high or too low. :) Thanks!

    – Rusty

  10. Here I am 8 months after the article posted and grateful it did. It give’s me a better understanding on how to analyze my investment project. It also made me realize that the property class A, B, and C is similar to how you classified your cap rates. So thank you for the article. Looking forward to hearing how you calculate the other aspects of investing.

  11. Ali,

    This is an awesome article! You are right on!
    I have properties with a 20% cap rate and they are work! So much work!
    However since not many property owner/managers want to mess with such stress I find the barriers to entry much lower! I am also good dealing with people of all different socioeconomically groups.
    I wish you well with your investing!

  12. Great article Ali. Most of my cap rates are around 7% in this expensive DC area. My confusion lately is if I have a cheap property vs an expensive on with same cap rate. What is better? Better tenants maybe in the latter. But much higher possibility of paying off a cheaper one. So that’s my dilemma these days.

    • Hi Scott. Well this is a debate that everyone can have different opinions on, so I far from claim my opinion be the only right one. Preference will always be an issue for sure. But for me personally, 1. I only buy more expensive properties and 2. I never want to pay anything off.

      1. I’ve learned the hard way that tenant quality will make or (tragically) break an investment. The cheap properties will increase the risk of bad tenants. Also cheap properties are likely older, so they need more repairs. Appreciation potential is also less. So I believe in the long-run, the returns on a more expensive home will always be higher. Of course some of that statement will be market-dependent, but you get my drift.

      2. I’m a huge fan of leverage. I don’t buy into the idea that leveraging is more risky than paying all-cash for a house. Plus the returns are higher when you leverage. So even if I were to pay off a property, I would use that equity to immediately refi or take a mortgage on it to buy more properties. But there are a ton of people who will argue the total opposite, so it’s up to you.

  13. Hi Ali, great article. You laid out the 3 cap rate categories nicely. I own multiple properties. For high quality low cap rate properties, it is a no brainer to take out loans with high Loan-To-Value Ratio to leverage the returns. For high cap rate low quality properties, it’s better to take out loans with low LTV or pay cash as I believe they are certain to experience delinquencies and vacancies or excess inventory in tough economic environments. The renters are on the edge, and any adversity would push them over.

    My low cap rate properties have similar returns as my high cap rate properties after leverage. My last loan was locked-in in November when the rates dipped down.

    The mortgage rates are not so good anymore. What kind of financing are people using now, if any?

    • Hi Bill. You make some great points and your thoughts are totally on-par I think! Great advice about leverage versus not.

      What do you consider “good” mortgage rates? While the rates have gone up, they are still at only about 5% for investment properties which is still excellent (beats 18% like it was back in the 80s!). Everyone I know is trying to get as many mortgages as possible and then after that, private financing or paying all cash is usually what happens.

  14. Steve Sanchez on

    Great article Ali!

    I’m looking forward to any articles you may be writing about investing in Nicaragua!

    ~Steve

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