Investing for cash flow- Cap Rates the 'end all- be all?

18 Replies

Good afternoon all.  First time investing and I'm curious your thoughts on this.  If you are an investor that's main focus is cash flow, why not simply find the highest cap rate you can find and invest in those properties?  What are the risks with that approach as long as you do your due diligence on the #'s of each deal and they look solid.|

Thank you in advance.

-Joshua

Generally speaking, those high cap rate and high cash flow properties are very risky. The risk comes from being in at best rough areas at worst they are absolute war zones. The people that live here often don't do it by choice rather it's one of it not only the only option. The chances of your property getting destroyed is much higher (theft, revenge, bad tenants etc). You're going to have higher than normal turn over and you're almost never going to be able to collect against anyone who stops paying or destroys your place. Oh and getting funding for loans under 50k is a pain.... and no one but investors are going to want this property so your exit plan is limited.

But hey they look great on paper... 30k house, rents for 7-800 mo.

I would answer that it really depends on your risk tolerance. Higher cap rates are that for a reason. Even if you do your "due diligence", there has to be some rationale, some of which may be completely outside your control (geographic marketplace, loss of industry, etc) that creates a high-cap situation. If you buy in something that's got relatively poorer returns right now - say SF or Denver or similar - there's a reason for that, too - you're purchasing security. If push comes to shove, is the property in Akron or Denver going to be more attractive to more people looking to park safe money? 

Also, to add... one way to reduce risk in this niche is through experience. You can do very well in it, but it's gritty and hands on. It takes a special kind of person and not everyone is cut out for it....


Instead of looking at numbers... look at value. There are things that create value outside of a "high/low" cap rate.

@Joshua Levine just make sure you’re making money. It’s one thing to go with low cap rates, but if they don’t really make money it’s a waste of time. I buy houses all day for $50k-$75k. $15k down. Mortgages around $200-$300/Month PITI. Rent for $800-$1,200/Month. Easy 40%+ return annually. So what if they have worse tenants... screen them better before hand.

Thank you all. Great responses! I appreciate the quick help and detailed responses!

@Joshua Levine -  What everyone said above is exactly true. The higher the cap rate, the higher the risk typically. One strategy that I think is cool is purchasing a lower cap rate property and using your business acumen to increase the cap rate by either increasing income or decreasing expenses. 

Once you stabilize the property, you can either keep it for yourself OR rent it out,

Originally posted by @Joshua Levine :

Good afternoon all.  First time investing and I'm curious your thoughts on this.  If you are an investor that's main focus is cash flow, why not simply find the highest cap rate you can find and invest in those properties?  What are the risks with that approach as long as you do your due diligence on the #'s of each deal and they look solid.|

Thank you in advance.

-Joshua

 Higher cap = Higher risk.

When it's going good cash rolls in. However it can turn on a dime. When it's going bad cash pours out.

The move with low quality, high cap rate properties is scale & reserves. You want to quickly purchase enough properties that your performing properties help carry your non performing properties. On top of that ensure you have enough reserves to handle anything that comes your way.

Originally posted by @James Wise :
Originally posted by @Joshua Levine:

Good afternoon all.  First time investing and I'm curious your thoughts on this.  If you are an investor that's main focus is cash flow, why not simply find the highest cap rate you can find and invest in those properties?  What are the risks with that approach as long as you do your due diligence on the #'s of each deal and they look solid.|

Thank you in advance.

-Joshua

 Higher cap = Higher risk.

When it's going good cash rolls in. However it can turn on a dime. When it's going bad cash pours out.

The move with low quality, high cap rate properties is scale & reserves. You want to quickly purchase enough properties that your performing properties help carry your non performing properties. On top of that ensure you have enough reserves to handle anything that comes your way.

 Thank you, James.  I am still working through my investment strategy and what kinds of markets to target.  I live in the NY/CT region where cap rates of 2-4% are common and it's very expensive to buy.  I want to enter a market where I can see consistent cash flow.  I am not completely risk adverse, but I certainly don't want to invest in an area where I will have to deal with high levels of eviction, poor tenants, etc.  Thank you all for the excellent answers.  I may look for area's with mid level caps (6-8%) and properties where I see a value add (like Craig said to do) and increase the cap over time.  If I can reduce the expenses by negotiating contract expenses or billing back utilities to residents, even better.

Have a great weekend all. 

Best,
Joshua 

@Craig Curelop

@Joshua Levine

Well I think the classic value add strategy is to buy a property and use your business acumen to increase the property value by increasing NOI, not increasing Cap Rate:

- Cap rate is market driven, investors can not control (i.e. increase/decrease) cap rate. Cap rate is a measure of how desirable the properties are in certain markets.

- Just within this thread, there are at least two posters saying "higher cap rate = higher risk". If you could control cap rate, why would you want to buy a property and use your business acumen to increase cap rate? Wouldn't that mean you would increase the risk? (Higher cap rate = higher risk, right?)

Cheers... Immanuel

@Immanuel Sibero - Cap Rates are often referred to when looking at markets. However, it can also be used when determining the value of a particular property to get an idea as to how profitable the property will be. 

Mathematically speaking, if Cap Rate = NOI/Purchase Price then by increasing the NOI, you are also increasing the Cap Rate. That's what we mean here.

@Joshua Levine high cap rates are higher risk. Also cap rates are only one measure and should be your “initial” go no go on a property. Property should be acquired based on its forecasted yield.

As an example, cap rate is the last years NOI/asking price. Would would you rather own a property with NOI of $15,000 and pay $100,000 but property has deferred maintenance that will cause it to need $30,000 repairs within next three years or a property that has an NOI of $8,000 and costs $100,000 but is new construction?

@Craig Curelop

Do you agree with the guys saying that higher cap rate = higher risk? Once you increase the cap rate of your property, does it now carry more risks?

In my market, the cap rate is 7%. If I bought a property making $70,000 NOI, it would cost me $1,000,000. If in a year's time, I improve the property so that it makes $80,000 NOI, I would likely be able to sell for around $1,142,857 (NOI of 80,000 / Cap Rate of around 7%) giving me a profit of $142,857. This is the way I understand how the cool value-add strategy that you referred to in your initial post. Notice that the cap rate doesn't change much but NOI has increased. Can you give an example of how to realize profit using this same value-add strategy by increasing cap rate?

Cheers... Immanuel

I don't consider a higher cap rate higher risk necessarily. If the property is very high maintenance, hassle, and drama from tenants, most property managers will not touch it. If you self-manage the higher return has to be high enough for you to give up your time and money to take care of the property. That isn't a risk so much as a pain in the rear, therefore the seller is willing to give away some profit in order to get rid of a problem. The goal would be to buy their problem, fix it, and make some money. Some say there is no such thing as a bad property, just bad managers.

@Joshua Levine

While I do always take a glance at the cap rate, I honestly do not base my decision on that. Reason being, I'm never going to buy the deal for what the seller is asking and there are other variables that need to be factored that are sometimes not accounted for in the CAP Rate equation. Honestly it's as simple as taking the numbers given to you, plugging them all in and seeing what you want to offer based on the cash flow your looking for on the deal. A basic analysis of the income and expenses along with some research on the area tells the story.

Originally posted by @Joshua Levine :
Originally posted by @James Wise:
Originally posted by @Joshua Levine:

Good afternoon all.  First time investing and I'm curious your thoughts on this.  If you are an investor that's main focus is cash flow, why not simply find the highest cap rate you can find and invest in those properties?  What are the risks with that approach as long as you do your due diligence on the #'s of each deal and they look solid.|

Thank you in advance.

-Joshua

 Higher cap = Higher risk.

When it's going good cash rolls in. However it can turn on a dime. When it's going bad cash pours out.

The move with low quality, high cap rate properties is scale & reserves. You want to quickly purchase enough properties that your performing properties help carry your non performing properties. On top of that ensure you have enough reserves to handle anything that comes your way.

 Thank you, James.  I am still working through my investment strategy and what kinds of markets to target.  I live in the NY/CT region where cap rates of 2-4% are common and it's very expensive to buy.  I want to enter a market where I can see consistent cash flow.  I am not completely risk adverse, but I certainly don't want to invest in an area where I will have to deal with high levels of eviction, poor tenants, etc.  Thank you all for the excellent answers.  I may look for area's with mid level caps (6-8%) and properties where I see a value add (like Craig said to do) and increase the cap over time.  If I can reduce the expenses by negotiating contract expenses or billing back utilities to residents, even better.

Have a great weekend all. 

Best,
Joshua 

 Sounds like a reasonable plan to me.

@Immanuel Sibero - I do not 100% agree with that. I just think generally, a higher cap rate means higher risk. There are obviously exceptions. 

We are talking about two different things. You are talking about the market's cap rate and I am talking about the specific property's cap rate. A specific property's cap rate is a good ballpark estimate as to how profitable the property is relative to price (in a buy & hold scenario). Similar to a Price to Earnings ratio in stocks. 

A cap rate is simply the NOI divided by the purchase price. In your example. You bought a property for $1.0M and NOI is $70k, your cap rate is 7%. If you increase the NOI to $80k, your cap rate is now 8% which means you have increased the profitability by making good business decisions. It will not impact the entire market.

If the market cap rate is still 7% then yes, you will likely still be able to sell for the $1.1M number you mentioned above. 

Good advice on this thread about risk vs return. Higher maintenance property that attracts high maintenance tenants = Good cap rate but it comes at a cost. You have to decide your business model and how hands on you’re willing to be.

That being said, from a pure numbers perspective the key metrics I look at are cap rate and cash- on- cash return. The latter is more important as it represents actual return on investment net of appreciation and debt retirement.

@Craig Curelop

Thanks, yes I understand about "property" cap rate. I'm a relative newbie so when I see cap rate I think of "market" cap rate (i.e. the only kind of "Cap Rate" I have learned so far). Just a note to myself that sometimes people mean "property" cap rate when they say cap rate. I hope you can see how it can be confusing to newbies like myself. To get out of this confusion, sometimes I tell myself that "property" cap rate is really the Yield (i.e. operating yield which is NOI/Purchase Price) of the property. All of a sudden, things start to add up better conceptually:

- The higher the yield, the better the property.

- Increase yield, increase the value (i.e. classic value-add)

- Increase yield, does not necessarily increase risk.

Thanks for your time, Cheers... Immanuel

Free eBook from BiggerPockets!

Ultimate Beginner's Guide Book Cover

Join BiggerPockets and get The Ultimate Beginner's Guide to Real Estate Investing for FREE - read by more than 100,000 people - AND get exclusive real estate investing tips, tricks and techniques delivered straight to your inbox twice weekly!

  • Actionable advice for getting started,
  • Discover the 10 Most Lucrative Real Estate Niches,
  • Learn how to get started with or without money,
  • Explore Real-Life Strategies for Building Wealth,
  • And a LOT more.

Lock We hate spam just as much as you

Create Lasting Wealth Through Real Estate

Join the millions of people achieving financial freedom through the power of real estate investing

Start here