Rental Property Investor · Charlotte, NC · Member since 2019 · 100 posts · 26 votes
Why are high cap rates usually considered risky? Are they not profitable for their high returns? Or is it likely risky because the seller is selling even though there are such high returns?
Are high cap rates simply on average risky, though some may not be?
I am confused simply on: what part of the equation of a cap rate includes such risk?
In general, mobile home parks follow the same "risk vs. reward" metrics as all real estate. In Sam Zell's book "Am I Being Too Subtle?" he says that you should always buy deals with high reward and low risk and never buy deals with low reward and high risk. So if you assume that all deals with high reward (high cap rate) must have high risk, then that's why you would think that any deal with a high cap rate must have above-normal danger to it. However, it has been our experience that many moms and pops price their property inappropriately so this formula is not always accurate. For example, if the seller has a deal with good infrastructure, density and location but has it priced too low due to poor knowledge of the market, then you have a high reward/low risk situation. We see this most often when the mom and pop have rents that are hugely below market (like a park we bought in Austin with $240 per month lot rents when the market was $550) and all you have to do to hit an insanely high cap rate is simply to raise the rents significantly.
The bottom line is that you should not assume that all high cap rates = high risk. That's only in a perfect market where pricing is accurate -- and most mobile home park pricing is anything but perfect.
In general, mobile home parks follow the same "risk vs. reward" metrics as all real estate. In Sam Zell's book "Am I Being Too Subtle?" he says that you should always buy deals with high reward and low risk and never buy deals with low reward and high risk. So if you assume that all deals with high reward (high cap rate) must have high risk, then that's why you would think that any deal with a high cap rate must have above-normal danger to it. However, it has been our experience that many moms and pops price their property inappropriately so this formula is not always accurate. For example, if the seller has a deal with good infrastructure, density and location but has it priced too low due to poor knowledge of the market, then you have a high reward/low risk situation. We see this most often when the mom and pop have rents that are hugely below market (like a park we bought in Austin with $240 per month lot rents when the market was $550) and all you have to do to hit an insanely high cap rate is simply to raise the rents significantly.
The bottom line is that you should not assume that all high cap rates = high risk. That's only in a perfect market where pricing is accurate -- and most mobile home park pricing is anything but perfect.
@Owen Thornton to keep it really general, cap rate is simply an illustration of the expected "rate of return" that investors are currently expecting to receive, if they pay cash for a property. In other words, investors are asking the question, "What return would I make on my capital if I were to buy this property for cash?"
You will find there is always a current market cap rate for each specific type of property due to the recent sale of similar properties. When the market is strong cap rates get lower, and when the market corrects (like it did in 2007-2010) cap rates get higher. Also, nicer properties and neighborhoods will always have a lower cap rate than lessor quality properties and neighborhoods. The more desirable a property is, and the more desirable the location is, the lower the cap rate will be. (this is why a run down property in a tough neighborhood will have a higher cap rate)
Generally a higher cap rate will come with more risk, more work that needs to be done to the property, more intensive management, or a combination of all three. For taking those on, the NOI to you will be greater.
@Owen Thornton High cap rates in and of itself are GREAT. However typically high cap rates relate to a lower class neighborhood and lower class neighborhoods relate to lower class tenants and you know where I'm going with this. I buy alot in high cap rate areas and I know the properties will never really appreciate. The tenants are hit and miss and I prefer to place section 8 tenants in those properties. The risk is non-payment of rent, vandalism and other property damage. Hope that helps man.