What do you think is really a good cap rate?
Member since 2019 · 8 posts · 2 votes
I’m a flipper/investor and trying to figure out what to do after we sell this next flip. I hear varying opinions on what truly is a good cap rate if we decide to buy and hold next which I’m leaning towards, given our current local market. I’m curious about your opinions? Google searching is beyond cumbersome so I appreciate it if you don’t send me some link to a website and rather give me your opinions as experienced investors. Thank you in advance and i promise to return the favor with any advice i can offer as an investor/flipper and full time realtor. Thanks again.
If you're dealing with residential properties then cap rate has little relevance. Cap rate is more of a valuation/risk metric (more on this later). I notice when people use the term cap rate on BP, especially in regards to residential properties (i.e. where it is not even all that relevant), they really mean some kind of performance measure. In this case they mean yield, so they ask questions such as - what's a good cap rate? what's a minimum cap rate would you accept? etc. In this case, my 1 cent would be - a good performance metric in residential properties would be something like Cash on Cash, IRR, payback, etc.
As briefly referred to above, cap rate is more of market wide valuation/risk metric for commercial properties, so it's not even all the relevant in residential (1-4 unit properties). When investors invest in commercial properties they invest in the income (NOI) of the properties and cap rate is a metric that measures how attractive the NOI is in a particular market, given the risks associated with those properties. The attractiveness of the NOI is reflected by how many dollars an investor is willing to pay for each dollar of NOI. So conceptually, cap rate is really a measure of investors' attitude or sentiments towards the commercial properties in a particular area. In market areas with excellent outlook (i.e. good demographics, high income, growing economy) investors will bid up properties (i.e. offering more) because they expect rents will increase therefore NOI will increase. The more they bid up properties the lower the "cap rate" goes (i.e. you can observe this just by doing the math on the formula NOI/value). So for those of you who think the higher the cap rate the better, this doesn't make sense because low cap rate markets are always markets with excellent outlook. This goes back to the first paragraph - when cap rate is used as a performance measure then something doesn't make sense.
The reality is cap rate is NOT a performance measure so there really is no "good" cap rate. There really shouldn't be a "minimum" cap rate that an investor should accept. Cap rate should just not be used that way.
Cheers... Immanuel
@Stephen M. I personally look for deals where I can improve the property so that it operates at above an 8 cap. Often times my deals are purchased a really bad cap rates based on actuals (4 cap or 5 cap), but I can rapidly turn them around and get them stabilized in the first year. Cap rates are very market specific, and honestly I would be worried if a broker was selling me anything over a 7 or 8 cap in today's market. Most of the stuff I see being sold at "stablized 10 cap" really is just code for war zone.
Thanks so much John. Now this maybe a stupid question, but what makes say a 4 or 5 a bad cap rate? Of course you want to maximize your ROR, but is 7 or 8 the magic number based on the ROR in a property as opposed to placing in say an annuity? I see a lot of 7 or 8 numbers as the threshold so I'm curious why it's 7/8 an not say 4/5?
If you're dealing with residential properties then cap rate has little relevance. Cap rate is more of a valuation/risk metric (more on this later). I notice when people use the term cap rate on BP, especially in regards to residential properties (i.e. where it is not even all that relevant), they really mean some kind of performance measure. In this case they mean yield, so they ask questions such as - what's a good cap rate? what's a minimum cap rate would you accept? etc. In this case, my 1 cent would be - a good performance metric in residential properties would be something like Cash on Cash, IRR, payback, etc.
As briefly referred to above, cap rate is more of market wide valuation/risk metric for commercial properties, so it's not even all the relevant in residential (1-4 unit properties). When investors invest in commercial properties they invest in the income (NOI) of the properties and cap rate is a metric that measures how attractive the NOI is in a particular market, given the risks associated with those properties. The attractiveness of the NOI is reflected by how many dollars an investor is willing to pay for each dollar of NOI. So conceptually, cap rate is really a measure of investors' attitude or sentiments towards the commercial properties in a particular area. In market areas with excellent outlook (i.e. good demographics, high income, growing economy) investors will bid up properties (i.e. offering more) because they expect rents will increase therefore NOI will increase. The more they bid up properties the lower the "cap rate" goes (i.e. you can observe this just by doing the math on the formula NOI/value). So for those of you who think the higher the cap rate the better, this doesn't make sense because low cap rate markets are always markets with excellent outlook. This goes back to the first paragraph - when cap rate is used as a performance measure then something doesn't make sense.
The reality is cap rate is NOT a performance measure so there really is no "good" cap rate. There really shouldn't be a "minimum" cap rate that an investor should accept. Cap rate should just not be used that way.
Cheers... Immanuel
I agree with Immanuel Sibero. I always look at the cash on cash return. Before the financial crisis in 2008, it was not unusual to get a 30% cash on cash return. Those days are long gone, although there are exceptions. Rate of return should always be proportional to the level of risk. If the risk is low, it is not reasonable to expect a high rate of return.
Thanks everyone for your guidance. I really appreciate it and it all makes sense to me. I did a deal recently for a client and the seller was all about his "cap rate" on his investment condo for which is why I questioned the relevancy of it.