How Important is Cap Rate in the equation

Question

Hi BP community,

I am new to the BP forums but have been an active listener to the podcasts for a while. Have been spending the last few months sharpening my knowledge and skills to best arm myself for when I pull the trigger on a property. My goal is to build long term equity by buying and holding. I have been running a ton of cap rates and can not seem to find anything above 6% in the areas I am most interested in. My question is how important is a good cap rate in the grand scheme of things? Should I hold as much water in Cap rate as I have been doing lately or am I giving it too much credit? Lastly, what other factors should I also look into that can determine if the property is a good investment.

Really appreciate your insight and thank you in advance

Sidenote: Would love to connect with some local CT BP members if you want to connect

-Spencer

Russell Brazil · Answer

There is no such thing as a good cap rate or a bad cap rate.  Cap rate has much more to do with the underlying risk of the asset and market, and really has very little to do with return. (There is no such thing as a good or bad return either).  The higher the cap rate, the higher the risk of the asset/market, and the lower the cap rate the lower the risk.

Jacob Sampson · Answer

@Spencer Joseph - Here is the equation I use to judge properties.

Gross rent - 30% (vac, maint, and CAPEX) - PITI (principle, interest, taxes, and ins on a 15 year mortgage) = true long term cash flow.  I want the true long term cash flow to be around 15% of the cash I put in to purchase and renovate a property.  Also I want the home to be in a C+ or better neighborhood.

Keep in mind this is my own equation and it is pretty conservative.  Most areas in the US just don't have properties that meet these requirements.  I just happen to live in an area that does.

Spencer Joseph · Answer

Awesome, Thank you  @Charles Kennedy

Charles Kennedy · Answer

You are likely looking at your in-place cap rate. If you want a great deal, see how you can increase your NOI, and sell at a similar cap rate.

I.e. your property may bring in $20,000 in NOI today, but you see that you renovate for $20,000 increase rents $200/mo ($3000/year), and properties sell generally around a 6% cap, you can then sell the property for $20,000 more.

Numbers and rent increases obviously vary. Get quotes for rehab and also make sure you understand what your property will rent for post-rehab.

Sometimes the current owner may not even be charging full market rent. You may be able to raise $50/mo without even doing anything because the current owner is charging too little.

Don't look at in-place cap rates - that's what investors who are ok with high single-digit returns look at. You should seek double-digit returns by creating value where it's not obvious.

Spencer Joseph · Answer

@Jacob Sampson @Jeremiah Mon @Russell Brazil

Thank you all so much for the quick response and sharing. What I am looking for is single family homes mostly but wouldn't be opposed to condos or MF's (no more than 2 units, want to start small).

Question for you all, sorry if it is novice, but if cashflow is whats important is there an ROI % I should shoot for? What would be considered attractive cashflow? Or is that an ambiguous question since it can be different for everyone?

Thanks,

Jeremiah Mon · Answer

@Spencer Joseph

For Value-Add Multifamily, you can forget about your entry cap rate. It doesn’t apply to unstable properties. Set your purchase price once you have everything else in your underwriting to get the returns you need.

Set you exit cap rate to be 50-100bps above from your entry cap; depending on the risk of that particular market.

Jacob Sampson · Answer

Welcome and good luck with your efforts.  First question, what type of property are buying?  Apartments, SFH, small multifamily, commercial?

It is not suprising that you are finding good deals, right now.  Prices are high.  That being said, if you are purchasing SFH or small multi (less than 5 units), don't bother with cap rate calculations.  Cap rate is primarily used for commercial

For SFH and small multi just estimate income and expenses and calculate what your cash flow and ROI will be.

How Important is Cap Rate in the equation

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