What are the pros and cons regarding high cap rates?

75 Replies

I have recently read a post that mentioned high cap rates can be risky?

I am new to investing and up until the other day, I believed that the higher the cap, the better the income. What are the pros and cons of this? I am leaning towards obtaining some MFRs and I want to be sure Im doing my research right.

Hi George -- good question.  I've been asking myself the same question recently. 

I think the tradeoff is that, in low-cap areas, there tends to be higher increases in rent rates, whereas high-cap areas do not have much natural rent rate increase opportunities. 

The "the wind is at your back" when buying low cap areas because the market forces tend to allow for increased NOI through rent increases (with expenses being the same). The downside, though, is that your initial cashflow when buying the low-cap areas is minimal, and sometimes even negative!

Thus, it depends on whether you're hungry for CF immediately, or whether you don't need the cash now, but want long-term value creation in the asset through NOI increases ("forced appreciation").

Interested to hear what others have to say...

@Andrew Kniffen. Thanks for the reply,  yeah it threw me off and made me think twice about my search. I know that most low end areas have high cap rates, but another question I have is does this mean that rent control will be enforced also?

Rent control is a local issue, county-by-county.  You would have to find other investors in your area to get input on that.  

Whenever you see a high CAP you must ask yourself - why? There's always a reason, and most of the time it's not good :)

When you read Pro Forma, which presents you with a chain of logical information resulting in a CAP rate, it's important to remember that the rate is only as good as the information, and the information is nothing more than someone's spin...

Case and point - I put in an offer today on 100+ units. The asking CAP was at 9.5 - having done the research and using real numbers, it bacame clear that the true rate had I paid the asking price would have been 3.3%...

My offer reflected this lol

@Andrew Kniffen I sure will. And well put on that first reply. 

@Ben Leybovich I have noticed your point. All high caps are all in D- areas. ( section 8)

As a new investor, I dont know if I am ready to jump into those types of areas. I am currently reading the begginers guide by bp then the rewind book then I will check out pro forma

@George Lopez  Not exactly.  The offer I made today, if it happens, will be a solid 9.5 when stabilized.  Other stuff I own is easily 10, and I don't have any D Class in my portfolio.  In fact, I don't have any C Class either.  You just have to know what to look for...

@Ben Leybovich do you invest in 2-4 units or 5+?

sounds like I need to take some notes from you. I am looking for 2-4 units but i havnt had any luck in my searches. I have found some units that fit in my budget but they are in D class areas with a 9% cap rate.  I am not sure how to get started. Do you have any tips?

Well - the LOI today was for 120+ units - a little bigger than a duplex. But, I do have those as well.

Ready for this, George?  Million dollar advice - you are looking for deals that fit your budget.  Quit - nothing that fits your budget is any good.  Learn instead how to make your budget conform to the deals that are worth having...:)

I think I smell a blog article coming - I'll reference this thread, if it's OK with you

So @Ben Leybovich  you are applying a 9.5 cap to a property that by your estimate is offered at a 3.3 cap? (even though by its pro forms the claim is that it is listed at 9.5-cap.) Offhand,  that would be an offer at less than 50% of asking.  That seems so low as to not be worth your time.  What am I missing?

Ohm @Andrew Kniffin  - it's worth my time :)

My lips are sealed on this one until it unfolds, but in general you're right - most of my offers get turned down.  You see - I am not into the privilege of owning property.  I want things that make money... 

Cap rate is usually used to compare properties in an area or for getting a tentative purchase price for a property based on the current cap rates in the area.

Cap rate = Net Operating Income/Purchase Price, So the cap rate will increase either when net operating income (Gross Rent - Vacancy and other Loss) or when Purchase Price is lower. So when you are looking at Cap rate as a Buyer you want to buy at higher cap rate that would mean either the price is low or the net operating income is high. So if you are comparing two properties at same price the one with higher cap rate would mean has a better net operating income which in turns means that high cap rate property is better managed compared to the other. Many a times I have see cap rates being calculated by using pro forma numbers which is nothing but cooked up or hypothetical numbers. Which are usually calculated assuming higher rents, and lower expenses thus increasing the net operating income. I think one needs to be very careful when looking at Cap rates for a property by itself. Some times it can be used to justify the high sales price for a property. One needs to look at actual rents and expenses along with prevailing cap rates in an area to come up with the purchase price.

Correction - net operating income (Gross Rent - Vacancy and other Loss - Operating expenses)

Originally posted by @Himanshu Jain :

Cap rate is usually used to compare properties in an area or for getting a tentative purchase price for a property based on the current cap rates in the area.

Cap rate = Net Operating Income/Purchase Price, So the cap rate will increase either when net operating income (Gross Rent - Vacancy and other Loss) or when Purchase Price is lower. 

Properties don't have cap rates! A cap rate is the result of what someone will pay for a NOI. If the NOI is higher then you will pay more at the SAME cap rate.

Originally posted by @George Lopez :

I have recently read a post that mentioned high cap rates can be risky?

I am new to investing and up until the other day, I believed that the higher the cap, the better the income.

@George Lopez A Cap rate ONLY reflects what the market will pay for a NOI for a certain property type in a specific market at a particular time. If the NOI is $50,000 then it is determined by the market that say in the Bay Area at a 5% market cap rate the income stream is worth $1,000,000. That same NOI in Indiana would possibly be determined by the market to only be worth $416,666 in Indiana at a 12% market cap.

In a perfect world you could say those two properties are EQUAL, not better or worse or riskier. Both have the EXACT same NOI but after analysis by the MARKET the cap rate reflects the perceived risk and that is reflected in the cap rate that supports the market value of the NOI.

@Himanshu Jain thanks for the reply. 

@Bob Bowling thanks for the reply. . . . So what is the correct term for what I am talking about as far as multi fam units go?

@Bob Bowling that reply did help me out, a little confusing at first but I think I get the concept of what you mean.

@George Lopez We don't buy off of a CAP Rate - ever. We sell based on it, because idiots place purchase price using it and we cater to idiots when we sell. But, as @Bob Bowling alludes to, we do not place valuation relative to CAP Rate...it's a fools game.

CAP is a metric of the behavior of a marketplace. At best it'll tell us how to over-perform the marketplace, but even that is pretty useless most of the time, since you don't want to merely be 1 or 2 points better than the marketplace - what if the marketplace is stupid - that would make you 2 points smarter, which is nothing to be too excited about.

Markets are driven by people and perceptions, and people are driven by psychology. The CAP rate measures people's behavior - that's all. Better to use metrics such as Cash on Cash (COC), or Internal Rate of Return (IRR). These deal with flow of real capital - the IRR is much more difficult to use and to understand, and for a duplex or a fourplex you may be better off with COC. But, even those metrics do not measure the intangibles, and there are a lot of those...

You are confused - I can tell.  But, you're asking the right questions.  Keep studying, George!

Hope this helps.

@Ben Leybovich If I'm understanding IRR right (I was just looking into this a little bit last night), in order for Excel to calculate it you have to have a purchase as well as a sale. If you are planning to buy a property and hold onto it forever (correct me if I'm wrong, but that's been my understanding of what you do from reading your stuff), how do you go about accurately calculating that? Just run different scenarios for sales at each incremental year to see what it would be?

@Rodney Kuhl - yes. It's true that IRR requires termination price. You can, however, keep that the same as all in investment at the front door, in which case the IRR does not benefit by anything other than in-flows and out-flows throughout the normal operation of the building. Simply do 1 year at a time, and you should get clear picture of investment returns relative to nothing but P&L - which is what you want.

On syndicated deals which require a timed exit, we do project IRR based on a projected final pay-out...

@Ben Leybovich Ahh, thanks for clearing that up. I don't fully understand IRR at this point. I was playing around in Excel last night (yeah, I do that for fun - my wife definitely thinks I'm cool....not!) and didn't put that together. I'll give it a try later and see what it looks like. Thanks for clarifying how you do that!

@Rodney Kuhl One deceiving thing about an IRR calculation though. The IRR assumes all yearly net income is reinvested each year and yields the same rate of return as the overall calculated IRR. As in if you come up with a 12% IRR on net income for a 5 year holding period, it assumes all yearly cash flows are reinvested, and yield 12% net until the end of the holding period, which would be difficult for short term money. The higher the yearly cash flows, particularly on the front end, the more this number is skewed to the high side, assuming you can't match those yields.

As for "high cap rate properties", these are almost always unrealistic projections on D type properties, that assume "normal" vacancy/collection rates for stable properties and a disregard for higher levels of vandalism and such.  The projections are delusional, and if they were accurate the property wouldn't be trading at the supposed high cap rate (lower price) being advertised.

@Wayne Brooks  Also good to know. Thank you! So if I didn't want to account for re-investing all of the income, which calculation should I use?

there is a FMRR (financial management rate of return), don't believe it's common, learned back in the 80's.  Essentially, you manually bring your yearly cash flows forward, at a realistic net return, up to the end of the investment term.  You then have one lump sum FV at the end to calculate your return from.

@Ben Leybovich thats clever thinking. You dont buy into their thinking and set your own price for these properties.  You made it really clear to me. Ill keep reading and will study this stuff. Still trying to piece it all together but ill get it. 

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