Determining your Cap Rate

8 Replies

Hello BP! Can any experienced investor share their process for determining their personal target Cap Rates? I see a lot of blogs and listen to podcasts where seasoned investors have a distinct target for this number.  All I know is the basics- higher rate, higher risk/higher return.  I have never seen anyone put boundaries around cap rates that define them for specific asset classes or otherwise distinguish what they are looking for.  For example, if I tell you I look for Cap rates of 10 or less, what information does that convey to you?

Any insight greatly appreciated!

Higher CAP Rates don't mean higher risk all the time. There are many factors that go into a CAP Rate, such as where you are in the lease timeline, that will blow that statement out of the water. Also, your ability to negotiate the terms will also have more impact on the CAP Rate than the Risk Factor will,...or at least it should.

I don't have a set universal CAP Rate goal. The needed CAP Rate is different and based on where I am in the timeline of my REI Plan.

@Valerie K. If you tell me that you are looking for a cap rate of 10 or less then I am a bit confused. For example there are some apartment buildings in Austin area whereby the owner/seller is wanting to sell there property at a 1.55 cap rate by campus.. (good luck on that one, seller). The buyer will only get a 1.55 rate of return if paid all cash. If levered the rate of return is higher. If the seller gets off his/her high horse and becomes realistic thereby lowering the price then the rate of return goes higher. Do keep in mind that numbers will need to be analyzed and there is a bit of investigative work to determine if the numbers are accurate and whether or not the advertised cap rate is true. 

If you say that you are only willing to consider properties with cap rates of 9-11 for apartment buildings then that will keep you out of certain markets where properties are trading at much lower cap rates. 

Hope that makes sense. 

Hi Aaron! I threw 10 Cap out there as a random number. I'm just trying to understand the logic behind the numbers. I know what Cap rate is, but I'm trying to get a feeling for how experienced investors formulate their goals in a property and what they get in return. I hope that makes sense. I know there are rules like 1%, 2%, 70% ARV for flips. Should I even have a target cap date or is that incidental to the other parameters of the deal, ie purchase price, cash on cash, etc. I don't have a clear picture in my mind what a given cap rate is telling me about a property compared to another. I hope that makes sense. Thanks for your input, much appreciated.

@Valerie K. I think about a cap rate this way; if you were to put your money into a risk asset like real estate, what is your expected cash flow return requirement? It is all individual preference what you want to set YOUR threshold at. So at the end of the day you need to make a personal judgement call on what you are willing to exchange for in order to part with your capital and put it at risk. Those with a lot of capital or those investing with other peoples capital are able to accept and feel comforted much lower returns. Those with smaller amounts of their own capital who have to work extremely hard just to build that capital should be demanding higher returns. Again, you are parting ways with YOUR capital, and the exchange you make needs to be commensurate of the risk/return profile you are comfortable with.

I personally shoot for 5% cash flow returns on my investments. Any appreciation or other benefits are just cream on the cake for me. My rationale is that I can achieve around 4% through macro market ETF’s in the stock market which require no hands on work so 1% additional cash flow is commensurate for the amount of work I put into my buy and hold real estate investments. Again, that is just my preference and each individual is different.

Now, being able to achieve your threshold is dependent on the macro market cycle position, current interest rates, the micro market, the target asset quality, the neighborhood quality, and how you source your deals.

If you seek to buy in Austin, want to have a 10+ cap rate, sourcing deals that are listed publicly, you better be willing to buy properties with lots of deferred maintenance, high vacancy rates and in “war zones”. This may still be a difficult feat to achieve as the risk premium that is added to the risk free rate (treasuries) needs to be significantly large since the risk free rate is basically zero. This risk premium also varies with market cycles as demand for risk goes way down when there is blood in the streets and way up when the fed is printing money like crazy.

@Valerie K. Cap rates can tell you about how expensive one property is compared to another given an apples to apples comparison. For example, given the same submarket if one property is asking 4% cap rate and the other is asking for a 5% cap rate then the better deal is the 5% cap rate. The expected cash flows on day one on the 5% cap rate will be higher than the one selling at 4% cap rate. One can compare cities too by cap rates. For example if Austin multifamily class c between 25-50 units is selling at 3% cap rates and Detroit is selling with the same type property for a 7% cap rate then one will expect a higher cash flow from the Detroit property with 7% cap. But cap rates only show the expected cash flow at day one not the expected cash flow on day 2 when there could be a lease renewal happening at the austin property that bumps rent by $200 as compared to zero increase in rent for a lease renewal in Detroit. I am not picking on Detroit though. It's just an example. I think that pro formas for cap rates are good to look at but those numbers are made up and not real btw. 

@Valerie K. It really depends on your market and strategy, my sweet spot is class B areas where I can find a solid 6-8%, then I use leverage to get a better cash on cash return. 
Based on my experience 9-12% cap is C areas, you need to be more hands-on on management and you're betting only on cashflow as there is rarely any appreciation in these areas. 
Anything over 12% cap is D areas and the numbers only work on paper, the maintenance and turnover will eat your profit. 

Now a B-class property in the midwest obviously gonna have a higher cap than a B-class in South Florida, but Florida has a better appreciation, so once again it depends on what you're looking for. 

Also, everyone has a different method to calculate their cap rate, I personally like to integrate a reserve for maintenance and vacancy, but most people only integrate property tax, insurance, and PM fees.... 

In my opinion, cap rate is a false metric, you should watch your cash on cash return. 

I am so grateful for this community. I’m learning the lingo and what types of investments they apply to. I’m  going out of town, you’ve given me much to digest and think about! Appreciate all the feedback!