The problem with cap rates?

23 Replies

When I first learned about cap rates I thought that they were a great way to compare properties independent of any particular investors financing situation. It also sounded like every particular area/neighborhood would have a "standard" cap rate, which would also help in figuring out whether a particular deal was above, at, or below market rates.

However, now that I think I understand cap rates a bit better, they seem speculative, situation specific, and therefore unreliable as a tool for determining the merits of a deal.

I think this because the cap rate is so heavily reliant on the assumptions one makes about the costs of owning a property. My standard assumptions around costs include 8.33% vacancy, 10% property management, 10% maintenance, and 10% capex. However I am yet to see a single deal where anything close to these costs are planned for. The biggest cost seems to be some "actual expense" from the previous year which is generally around 5% of gross. Sometimes vacancy is included, but generally not - especially if the property is currently fully occupied. So with none of these costs accounted for, of course the cap rate is going to look great!?

Have I misunderstood something about cap rates? If you rely on cap rates when evaluating a deal, why do you do it?

You can use the 50% rule as a general estimate for your costs but these are all just estimates. With experience you will know what Is and is not a good deal. 1 single property can make you a different amount if money every year you own it.

James Wise, Real Estate Agent in OH (#2015001161)
216-661-6633

You are very correct. While CAP is a universal term, everyone calculates it differently.

You should use your own CAP rate formula on deals you're interested in so that YOU can compare deals that YOU are interested in.

You can't take anyone's word for it in this business.

Your guess at your expected cap rate will be based on the accuracy of your experience in the/that market, it's an estimate and not the basis for an investment decision. When cap rates are mentioned by sellers, or listing agents, you can pretty well ignore them, even if they are correct, without puffing and fluff, that is that owner's rate, your situation will never be the same.

50% is a drive by estimate, that can tell you if you should sharpen a pencil or keep on driving by. Not a basis for a good buy decision.

Learn to sharpen your pencil, know your market, accurate ARV and repair costs, time on market issues and lease up periods, your cost of money and best use of funds will tell you where you need to be. Good luck :)

Thanks everyone for confirming my understanding of cap rates.

@John Horner YES this is exactly what I do! I have my own cap rate calculation for every property I look at, and use that to compare against other/previous deals. The metric I really look at though is cash on cash return - again using a calculation based on my own assumptions and analysis.

@James Wise , @Bill Gulley totally agree that cap rate is just another rough rule of thumb, and that there is no black and white metric which will tell me whether to buy or not. Working on gaining my experience in evaluating my market, and the deals in it. Thanks for the help!

@John Horner Yes, COC is the most pragmatic way to look at things. In my spreadsheets I call it SMTM - for Show Me the Money! :-)

Originally posted by @Omi C. :
Thanks everyone for confirming my understanding of cap rates.

I have my own cap rate calculation for every property I look at, and use that to compare against other/previous deals. ... totally agree that cap rate is just another rough rule of thumb, and that there is no black and white metric which will tell me whether to buy or not.

What good is some made up calculation to compare to your previous deals? Are you thinking a cap rate predicts profitability? Do you realize that cap rates are property, location and time specific?

A cap rate is a specific calculation that tells you at what rate the MARKET is buying an income stream for a specific property in a specific location, at a specific time.

A cap rate is generally not used for small residential properties mainly because these owners do not report accurate income and expenses and there is no place where this information would be analyzed and reported. You would be better to use a GRM. It is easier to get/estimate market rents and sales prices. Then you can easily compare similar properties in similar locations.

Cap rates are definitely based on assumptions, so I rarely use them with houses or with seller pro formas. But with apartments, when you have real numbers, they are very helpful. They are also good when working out your own pro formas or estimates for how an apartment will perform.

Originally posted by @Andrew Syrios :
Cap rates are definitely based on assumptions, so I rarely use them with houses or with seller pro formas. But with apartments, when you have real numbers, they are very helpful. They are also good when working out your own pro formas or estimates for how an apartment will perform.

How does a cap rate estimate how an apartment will perform?

Originally posted by @Bob Bowling:
Originally posted by @Omi C.:
Thanks everyone for confirming my understanding of cap rates.
I have my own cap rate calculation for every property I look at, and use that to compare against other/previous deals. ... totally agree that cap rate is just another rough rule of thumb, and that there is no black and white metric which will tell me whether to buy or not.

What good is some made up calculation to compare to your previous deals? Are you thinking a cap rate predicts profitability? Do you realize that cap rates are property, location and time specific?

A cap rate is a specific calculation that tells you at what rate the MARKET is buying an income stream for a specific property in a specific location, at a specific time.

A cap rate is generally not used for small residential properties mainly because these owners do not report accurate income and expenses and there is no place where this information would be analyzed and reported. You would be better to use a GRM. It is easier to get/estimate market rents and sales prices. Then you can easily compare similar properties in similar locations.

We're not talking about picking a CAP rate and buying at that point forever. We're talking about tracking CAP rates so that we know what deals look like in relation to other deals in different areas at different times. If we track them correctly we will know when they start changing and when to adjust where, when and at what price point we buy.

On this site alone people use CAP rates to analyze SFH's all day, every day.

Lastly, I don't think anyone uses the sellers claimed info to calculate CAP rates, that would be irresponsible, I use neighborhood specific rental comps and expenses.

Originally posted by @Bob Bowling:

How does a cap rate estimate how an apartment will perform?

Sorry, I should have been more clear. I'm not referring to an estimate, I'm talking about the actual cap rate from the previous year's operating statement. That number is very useful. You should always be wary of estimates, especially when provided by a seller.

Originally posted by @John Horner :

We're not talking about picking a CAP rate and buying at that point forever. We're talking about tracking CAP rates so that we know what deals look like in relation to other deals in different areas at different times. If we track them correctly we will know when they start changing and when to adjust where, when and at what price point we buy.

On this site alone people use CAP rates to analyze SFH's all day, every day.

Lastly, I don't think anyone uses the sellers claimed info to calculate CAP rates, that would be irresponsible, I use neighborhood specific rental comps and expenses.

What difference does it make what a cap rate is in "different areas at different times"? The comparability is in similar locations at similar times. 1985 Detroit cap rate for commercial properties compared to LA 2002 ???

"On this site alone people use CAP rates to analyze SFH's all day, every day." I agree that they do so and they do so incorrectly. Can you explain how this analysis is done and how it produces any actionable result? Again, if you are using neighborhood specific rental comps why not use the easier and more accurate GRM process. And where are you getting neighborhood specific expenses?

Originally posted by @Andrew Syrios :
Originally posted by @Bob Bowling:

How does a cap rate estimate how an apartment will perform?

Sorry, I should have been more clear. I'm not referring to an estimate, I'm talking about the actual cap rate from the previous year's operating statement. That number is very useful. You should always be wary of estimates, especially when provided by a seller.

OK, so you are using actual numbers to compute NOI. This number is useful. But NOT to calculate a cap rate on a small residential property. But let's agree that you want to calculate a cap rate based on these actual numbers. What then? How does it predict how an apartment will perform. I'm assuming that "perform" means profitability.

People need to realize that a 15% cap rate can result in huge losses and a 7% cap rate can mean HUGE profits. A cap rate is NOT a measure of profitability.

Originally posted by @Bob Bowling:
Originally posted by @John Horner:

We're not talking about picking a CAP rate and buying at that point forever. We're talking about tracking CAP rates so that we know what deals look like in relation to other deals in different areas at different times. If we track them correctly we will know when they start changing and when to adjust where, when and at what price point we buy.

On this site alone people use CAP rates to analyze SFH's all day, every day.

Lastly, I don't think anyone uses the sellers claimed info to calculate CAP rates, that would be irresponsible, I use neighborhood specific rental comps and expenses.

What difference does it make what a cap rate is in "different areas at different times"? The comparability is in similar locations at similar times. 1985 Detroit cap rate for commercial properties compared to LA 2002 ???

"On this site alone people use CAP rates to analyze SFH's all day, every day." I agree that they do so and they do so incorrectly. Can you explain how this analysis is done and how it produces any actionable result? Again, if you are using neighborhood specific rental comps why not use the easier and more accurate GRM process. And where are you getting neighborhood specific expenses?

I already stated for my own investments I use COC return, but because we wholesale to investors, and all of those investors give us their criteria in CAP rates, we calculate those to find out where we stand.

Why wouldn't I want to compare CAP rates from an area on the West side of Columbus to an area on the East side? Completely different style houses, tenants, etc but I have the ability to invest in both areas, and CAP rate is a quick way to compare the 2.

As for expenses, depending on the style of house, location and price point, we can estimate rather accurately what expenses will be. Lower price points and worse areas will equal more vacancy and maintenance, brick homes will equal less CapEx, Condo's will equal much less overall main and capex but you will have the Condo Fees instead, more expensive homes will equal less vacancy and maintenance. Forecasts are forecasts, we estimate the best we can with the information we have.

Omi can you clarify if you are taking about single family houses or apartment buildings??

If apartment buildings are you talking 2 to 4 units or 5 units plus?

There are so many metrics to consider and deal size will play a huge role in that. Anything 4 units and under appraisers use the comparable sales approach where 5 plus units the weight is given to the income approach.

So to take a pure income approach to 2 to 4 units or residential will yield mixed results. Larger deals you get into seasoned investors and professional companies. Of course there will always be some that are not experienced.

With smaller properties it gets much more complicated and is like the wild west. The books are crap from the seller, the loan balance is small so only local banks want it, the loans are harder to do because the buyers tend to have less liquidity starting out and net worth, the buyers tend to not have a track record of owning that type of asset, etc.

Originally posted by @John Horner :
Originally posted by @Bob Bowling:
Originally posted by @John Horner:

Why wouldn't I want to compare CAP rates from an area on the West side of Columbus to an area on the East side? Completely different style houses, tenants, etc but I have the ability to invest in both areas, and CAP rate is a quick way to compare the 2.

Good for you using COC. Bad on you for furthering investment ignorance by selling based on "crap rate" criteria. But hey a guys gotta make money.

You answered your own question as to why you wouldn't want to compare cap rates for the west side to the east side, "Completely different style houses, tenants". You just lost any comparability! Are you actually telling investors HERE to only invest in the "higher" cap rate. Bad Man!

Ask yourself, WHY and WHO are buying at the LOWER cap rates? Local smart investors that understand the profitability of the local market vs the "imprestors" from out of state that are being sold higher "crap rates" on the wrong side of town because they don't understand what a cap rate reflects?

Originally posted by @Bob Bowling:

OK, so you are using actual numbers to compute NOI. This number is useful. But NOT to calculate a cap rate on a small residential property. But let's agree that you want to calculate a cap rate based on these actual numbers. What then? How does it predict how an apartment will perform. I'm assuming that "perform" means profitability.

People need to realize that a 15% cap rate can result in huge losses and a 7% cap rate can mean HUGE profits. A cap rate is NOT a measure of profitability.

With small residential properties, I usually just use rent/cost ratios and comps with my estimated cap rate as a distant third.

Cap rates are more of a method of valuation, i.e. building in a certain area/age/condition should have an 8 or 9 cap or whatever. It's basically a method of comping out apartments, at least as far as I'm concerned. And in that way, they are useful as 1) there aren't that many apartments to comp compared to houses and 2) a per unit price isn't very helpful when there are so many other differences between apartments.

You would have to have a very brutal debt service to not be profitable with a 15 cap. Cap rates basically shows what your return is compared to the amount the property costs, it's cash on cash return without debt service. And since debt service isn't tied to how well the property is being run, the actual cap rate (not the estimated) is useful in that respect.

Originally posted by @Andrew Syrios :
Originally posted by @Bob Bowling:

OK, so you are using actual numbers to compute NOI. This number is useful. But NOT to calculate a cap rate on a small residential property. But let's agree that you want to calculate a cap rate based on these actual numbers. What then? How does it predict how an apartment will perform. I'm assuming that "perform" means profitability.

People need to realize that a 15% cap rate can result in huge losses and a 7% cap rate can mean HUGE profits. A cap rate is NOT a measure of profitability.

With small residential properties, I usually just use rent/cost ratios and comps with my estimated cap rate as a distant third.

Cap rates are more of a method of valuation, i.e. building in a certain area/age/condition should have an 8 or 9 cap or whatever. It's basically a method of comping out apartments, at least as far as I'm concerned. And in that way, they are useful as 1) there aren't that many apartments to comp compared to houses and 2) a per unit price isn't very helpful when there are so many other differences between apartments.

You would have to have a very brutal debt service to not be profitable with a 15 cap. Cap rates basically shows what your return is compared to the amount the property costs, it's cash on cash return without debt service. And since debt service isn't tied to how well the property is being run, the actual cap rate (not the estimated) is useful in that respect.

But wouldn't you have more "profitability at a 20 cap? How do you use your computed cap rate to know that you are NOT paying over market? The "return" you are counting on so much is for ONE point in time. What about rent growth or decreases? Market appreciation? If you don't have comp sales HOW do you have cap rate comps!?

Omi, bottomline is cap rates can be "manipulated" to look higher than it actually is. There is no magic number that can't be changed to make the investment look better than what it is. As long as you can put it on a spreadsheet, someone can tweak it.

I rely on Cash-on-cash return but as you said it's dependent on financing. If you rely on cap rates, it depends on the NOI which as you rightfully concluded, depends on some assumptions of vacancy, management, repairs and replacement reserves. As I said in my podcast interview, real estate is NOT just about the numbers. Listen to it here if you have not already:

http://www.biggerpockets.com/renewsblog/2014/04/10/bp-podcast-065-creative-investing-wendell-de-guzman/#comment-157630

I bought a 30+ unit apartment which, based on the numbers look awesome. BUT, it turned out to be a TERRIBLE deal. I since learned from that experience when I bought my 100+unit apartment complex (which turned out to be wayyyyy better deal even though the numbers didn't look as good).

You have to know your market, the building and what's going on. If it's a HOT rental market, maybe you can use 5% vacancy instead of 8-10%. If you're willing to manage the building yourself, you can forego the 10% management fee. If the building is newer, why factor in 10% for capex...is that way too high? Why not use just 5%.

Originally posted by @Bob Bowling:

But wouldn't you have more "profitability at a 20 cap? How do you use your computed cap rate to know that you are NOT paying over market? The "return" you are counting on so much is for ONE point in time. What about rent growth or decreases? Market appreciation? If you don't have comp sales HOW do you have cap rate comps!?

I agree, cap rate comps are tough. You can look at comps on Loopnet and CoStar, but the cap rates listed there are questionable. Real estate agents may have a good idea of what cap rates should be in that area, same with appraisers (who it's always good to network with). But in many ways, cap rates are just a metric. So you think an area is a C+ area and you're comfortable with say a 10 cap in C+ areas, then you set your offer to get a 10 cap. It's a very inexact science, but then again, that's real estate in general.

@Joel Owens I'm looking at 2-4 plexes for now, but hope to graduate into larger properties. The fact that even for a small MF the valuations are not strictly based on income is a great insight. Why do you think that is? I understand that with an SFH most buyers are occupants and therefore have a lot of emotion tied into a particular deal. Wouldn't even a small MF purchaser be more of an investor, and therefore give more weight to income, expenses, and ROI?

@Bob Bowling I agree that cap rate alone (or any other numeric metric on its own) can't be used to determine whether to buy a property or not. I don't think anyone on this thread claimed otherwise. However, I do think that when it is applied appropriately, it can be a useful metric (in addition to COC, and others) to consider when evaluating a property.

@Wendell De Guzman I did listen to your podcast - great show! Fully agree that its not all about the numbers and that no spreadsheet should really dictate whether I buy a property or not. I'm still a newbie, and I don't know what I don't know. Conservative cost estimates are one of the my safeguards to ensure that I don't lose money on my first deal.

Originally posted by @Omi C. :

@Bob Bowling I do think that when it is applied appropriately, it can be a useful metric (in addition to COC, and others) to consider when evaluating a property.

There is nothing wrong with looking at expenses and income. In any thorough analysis you will have enough information to calculate a cap rate on any income property. The problem is in utilizing it when there is not reliable market data on cap rates for small residential properties. That is a major problem along with the complete lack of consistency in computing them. In your first post you stated,

"they seem speculative, situation specific, and therefore unreliable as a tool for determining the merits of a deal. "

Now you say they are a useful metric. I've been asking ANYONE to detail how they utilize a cap rate for small residential properties. So far, over several threads and several forums NO ONE has stepped up to the challenge. Omi C, will you step up to the challenge?

@Bob Bowling I actually agree with you that any advertised or external cap rate is close to useless. Thats the whole premise I started with after all.

However, if I'm evaluating a couple of properties, and I calculate *my own* cap rates for them, based on *my own* estimates/assumptions about cost, then its an interesting metric for me which I can use to see which property might perform better relative to their market value if my assumptions turn out to be right. This is what I meant when I said "when used appropriately". If that consideration isn't interesting or useful to you when evaluating a property, then more power to you.