All Good Pitchers Throw Strikes -- All High Cap Rates?

The #1 rule governing baseball pitchers is — throw strikes. If they can’t do that consistently, they can have Nolan Ryan’s fastball, Sandy Koufax’s curveball, and a change-up that’d make Trevor Hoffman cry, and they’ll never make it in The Bigs. This truism was hammered home to me as a college umpire. There are a couple dozen guys for whom I called balls and strikes who threw 93-98 mph. Two are in the majors. Another currently pitches for the Pirates. His fastball, as a JC pitcher, reminded nobody of The Big Unit. Ditto with his other pitches. Yet, all he did was get guys out, and win.

He not only threw strikes, he threw unexpected pitches for strikes. In other words, he was a pitcher in the strictest definition of the word. The other guys? Today we call them FedEx drivers, accountants, and real estate agents. When they were called pitchers, they were actually throwers. Analysis showed them to be pretenders — guys blessed with strong arms who never knew where any particular pitch was gonna land.

Real estate investors are often fooled by inordinately high cap rates. Experienced coaches/scouts aren’t fooled by hard throwers, but almost always think they can teach them control. One of the A-List baseball clichés? You can’t coach 98 mph. How many times have you seen an income property with a double digit cap rate, only to learn it was, for one reason or another, a mirage?

Why is the cap rate so high?

Much of the time, possibly the majority, is cuz nobody in their right mind would buy the piece of crap (technical real estate investment term) if it didn’t offer a 15% cap rate. The fear of exiting your car is often a conditioned response to high cap rates. If the demand was so high, the cap rate wouldn’t be so impressive. Until you admit to that reality, you’re doomed to suffer the unhappy consequences of ignoring reality. There are those who will react badly to that, but I’m delighted to let them have those properties.

The second leading reason a property’s cap rate is high, is the cash flow analysis — specifically the process used in arriving at the NOI. (Net Operating Income) The expenses represented are low. Often, the income is projected. Let’s don’t even get into vacancy rates. Can’t tell ya how many calls I’ve taken from investors who’ve been ambushed by an inordinately high cap rate property. 15% turned into 6% in six short months. Initial projections of envious cash flow turns into a whole buncha nothin’ faster than they can watch it happen in real time.

When analyzing property it’s been my preference for exact numbers obtained by my own empirically conducted research. I trust very few people. My boots, my clipboard, and their lips to my ears or it’s suspect at best.

Some have what’s called the 50% rule. They simply divide the annual income by 2 to get an NOI they trust. That’s not a horrible rule of thumb with 1-4 unit residential income. The properties I’ve been recommending to folks the last few years, would break even with no money down, and vacancy/operating expenses of 45%. Yet I still insist on 95% of clients putting at least 20% down.

Even if that killer high cap rate is real — verified by your own boots-on-the-ground research — would you put Mom there to live alone? If not, and you still want it, is it something you’re willing to manage? Gonna keep it through your retirement for income? Outa town for the weekend? Gonna send your wife to collect a late rent?

Most inordinately high cap rate properties are the investment version of hard throwers who couldn’t hit water from a boat in a storm in the middle of the Pacific. Why would you do that to yourself on purpose?

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.