What are the pros and cons regarding high cap rates?
Downey, CA · Member since 2014 · 20 posts · 7 votes
What are the pros and cons regarding high cap rates?
Most Popular Reply
Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes
11yWhenever 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
75 Replies
Hi George,
Seeing that your are from So Cal, I would be very wary of anything with a substantially higher cap rate than what the market is selling at. As @Ben Leybovich mentioned, there has gotta be something wrong and in my opinion something fishy going on. For us Southern Californians, I would be leery of anything above a 6 or 7 cap let alone a 9 cap like you mention. For a 9 cap, you are probably dealing with rent control and/or some very tough tenants.
Unfortunately, there is a lot of investment money in Southern California which (a) pushes all the cap rates down and (b) smokes out all the good deals. So unless you are personally finding these high cap rate deals off market or through your own relationship, just be careful.
- Investor/Developer · Los Angeles, CA · Member since 2010 · 107 posts · 92 votes11y
@Account Closed is right cap rates reflect risk on a cash flow to help you compare the NOI from one property to another in a particular market. Further, it only provides a peek at cash flow for one year which can be very dangerous.
As was noted in another comment "proforma" or "projected" cash flows can be completely fabricated and should not be relied upon. We always buy off Actual cash flow and after reviewing rent rolls and actual expenses.
Be very careful not to make assumptions about areas or properties simply based on cap rates and even more careful about applying cap rate advice (rate specific) from one market to another. For example a 9% may be difficult or impossible to find in Los Angeles, but commonplace in Ventura or Riverside counties. A 3% cap rate may be common in New York City but ludicrous in Phoenix, Az. You get my point.
Another note, if you're buying 2-4 unit properties, specifically in metro Los Angeles markets you can set all of this aside. These properties are difficult to buy off income for the present moment in this market. You're competing with homeowners who buy units to live in one and offset their mortgage payment with the other units, and/or investors who buy, renovate and quickly sell these properties to those same owner/users. It may be temporarily impossible to find small units (2-4) in Downey and the surrounding cities that will cash flow as buy and hold properties, especially if you need to get a loan.
@Wayne Brooks thanks for the blast from the past, I haven't heard anyone discuss a FMRR since graduating college. Love it!
Best of luck
A
-
- 11yRoy N.Pro MemberRental Property Investor · Fredericton, New Brunswick · Member since 2013 · 7k+ posts · 4k+ votes
Originally posted by @Rodney Kuhl:
@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?
Rodney,
Look into using either the Modified Internal Rate of Return (MIRR) or the Financial Management Rate of Return (FMRR).
MIRR assumes positive residual cash-flow is reinvested at your opportunity cost at not at the same rate as the investment itself.
FMRR, which is most common a metric used in evaluating REITs, allows you to specify your in-flow and out-flow at two distinct rates. The calculation is a little more involved than IRR or MIRR - you may decide the value of the metric does not warrant the mental gymnastics.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes11y
We just covered this yesterday I believe on CAP rates, your rate will never be what the previous owner's was, even if you could evaluate with like kind properties.
Actually, an annuity stream is or can be brought back from each payment period with reinvested amounts at a different rate within the IRR, but it's not in your calculator. The Manger's Rate of Return is better and you can then factor in economic valuations as to management and opportunity costs. Large cash flows are viewed in this manner, you're even considering float on the money, but at small investor levels it isn't worth the effort, nor will the assumptions be accurate enough to give you a real or meaningful result from a proforma standpoint. Historically, you can see where you were.
Performance ratios from finance and accounting don't show the same feasibility as they do with securities which are graded and can be viewed as "like investments" real estate is unique and no two properties are the same nor are they very often really that similar, unless they are very close together.
Use COC, actual numbers as mentioned.
CAP rates are a guess in a proforma. Not something to rely on in a purchase.
Claims of, or even accurate historical, higher CAP rates of an owner may indicate lower expenses, differed maintenance, higher rents from older lease obligations, unusual low vacancies due to external factors subject to change in the market, accounting differences on an accrual basis, changes in depreciation from capital improvements or administrative factors.
I never met a financial ratio that made me more money to bank on from a property. :)
- Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes11y
I didn't read all of these posts.
Short and simple is in bad areas you will find high cap rates. Those properties tend to be a cash flow only play where you have to work very hard for that extra yield.
The rent increases tend to be minimal due to that type of tenant base living hand to mouth. So years later generally people sell for what they bought it for or less.
What most want to buy including me if I did a value add deal is a property half occupied for example that is in a GREAT area. The going in cap might be low but the stabilized cap will be way above market for the area.
So say the area is at a 6 cap. You buy going in at a 6 with 50% occupancy. The cap turns into a 9 once you get it fully performing. Now you can sell it say one year later at a 6.7 cap when the market is at a 5.9 and buyers will be all over it.
I either want to find an above board cap rate for a fully performing property in a great area or a value add lease up where I can increase the cap. These properties sell due to partnership splits, estates where heirs want to cash out, divorce, health issues, relocation, retiring landlord, etc.
On the commercial side I have also ran into situation where a developer has built a brand new center. They sell off a few buildings but then are developing larger projects elsewhere. They decide to sell brand new product as-is only 50% leased up. A buyer can go in and create much higher equity for themselves once filled up.
Everyone really needs to think about quality of the area and exits when buying.
- Minneapolis, MN · Member since 2014 · 332 posts · 288 votes11y
My firm looks at cap rate as a way to gauge where the market sits at that current point in time. Do we ever buy a property based solely on cap rate? Of course not. But, it does have it's place in helping a buyer get a sense for the marketplace and where deals are trading. We typically buy 200-300 unit multifamily properties and have purchased 10 in the past 12 months.
We get our cap rate information from top brokers who selling hundreds of millions of dollars of apartment deals per year to help us get a gauge on the market. Also, we look at cap rates when determining what markets to research further and which to avoid.
- 11yMike D'ArrigoPro MemberTurn key provider · San Jose, CA · Member since 2010 · 4k+ posts · 3k+ votes
@George Lopez As with any investment, the higher the risk, the higher the return it should demand. That's why lower rated bonds and paper offer higher yields than higher rated ones. In general, that applies to real estate also. Typically, low end properties in high crime areas will have a higher return at least on paper. But too often, those returns don't pan out. High vacancy rates, damage and turn over costs in these low end properties often wipe out your cash flow. I often hear people say that they can make them work with good property management, but so far I haven't found the property manager that can convince good, paying tenants to live in an area with rapes, robberies, assaults, shootings, drug dealing and prostitution going on around them. These areas can be deceiving sometimes. They might not look so bad when you drive around them during the daylight hours, but don't dare go in to the area when the sun goes down. If you want to know if an area is a bad area, all you have to do is look at the price of the homes and the rents. These homes are cheap and have low rents for a good reason. In my opinion, it's a big mistake for an inexperienced investor to buy cheap, low end properties. There's just too much risk.
- Real Estate Agent · Chesterfield, MO · Member since 2014 · 101 posts · 28 votes11y
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%...
So @Ben Leybovich, can you please elaborate on what you did here with an example.
This is what I understand you did,Assuming Asking price = 1000000
Cap rate = 9.5%So Net operating Income= .095*1000000=95000
Offered Cap rate = 3.3%
Purchase Price= 1000000
Net Operating income = .033*1000000=33000I am assuming after due diligence this is what the Actual net operating income is
Assuming the prevailing cap rate for this market is 8%
Take actual NOI = 33000So the tentative purchase price can be= 33000/.08= 412500
Assuming the market cap rate is what seller is projecting 9.5%
the tentative purchase price could be = 33000/.095 = 347368
So I am not sure how you use these numbers to make an offer. I think it will be very helpful if you can share some insights on how to use these.
- Downey, CA · Member since 2014 · 20 posts · 7 votes11y
@Mike D.Arrigo as a new investor, I am limited in funds, but I am currently reading some material that will hopefully help me be able to afford alot more for my money. It is true, you cant expect to have good tenants living in fear and especially not around some criminals. Thanks for the reply.
- New Port Richey, FL · Member since 2014 · 32 posts · 1 vote11y
@Ben Leybovich Hi Ben! I want to start investing in multifamialy properties 100+ units. I was woundering if you have any advice or tips for starting out?
- Houston, TX · Member since 2014 · 62 posts · 23 votes11y
Low or High Cap Rate depends on who is evaluating the property. Investors (buyers) want to have a high cap rate, meaning the value (or purchase price) of the property is low. Conversely, landlords (sellers) want to see a low cap rate because the selling price is high.
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
@Kyle Bentz - thanks for the chuckle :)
100+ is perhaps a good goal for you. However, a triplex might be a better place to start.
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
@Himanshu Jain - very good! Assume the following Pro Forma OM numbers (rounding):
Gross Potential income: $895,000
Effective Gross income: $920,000
Operating Costs: $330,000
NOI: $595,000
Asking: $6.1 mil
Now assume underwriting as done by me, my partner, and a PM with 15,000 units under management:
Gross Potential income: $900,000
Effective Gross income: $835,000
Operating Costs: $335,000
NOI: $203,000
LOI: $2.5 mil
This was declined. This seller is not motivated - yet. Someone will pay more than the thing is worth. I am only interested in property that creates returns for my investors and me. If you study the OM numbers, this should offer a lot of value to you in understanding the realities out in the marketplace. Just ask yourself - how likely is it to run 100+ units on Operating Costs of $330,000...
Your analysis was actually very good indeed! I feel an article coming :)
- Real Estate Agent · Chesterfield, MO · Member since 2014 · 101 posts · 28 votes11y
Originally posted by @Ben Leybovich:
@Himanshu Jain - very good! Assume the following Pro Forma OM numbers (rounding):
Gross Potential income: $895,000
Effective Gross income: $920,000
Operating Costs: $330,000
NOI: $595,000
Asking: $6.1 mil
Now assume underwriting as done by me, my partner, and a PM with 15,000 units under management:
Gross Potential income: $900,000
Effective Gross income: $835,000
Operating Costs: $335,000
NOI: $203,000
LOI: $2.5 mil
T
- Real Estate Agent · Chesterfield, MO · Member since 2014 · 101 posts · 28 votes11y
Can you elaborate on following
1)How you got to the NOI of 203 based on the number provides, What is missing here?
2)How did you come up with LOI (Letter of Intent) Price? What all did you use to come up with tentative offer/purchase price?
- Investor · Brodheadsville, PA · Member since 2013 · 98 posts · 21 votes11y
Just a stupide question about GMR. What value does it have and how much of it is random numbers per area. I speak about GMR to most REA and they look at me if from another planet. I know it takes an intimate knowledge of an area to do this comparison but is it on par with CAP when figuring a deal?
- Investor · Brodheadsville, PA · Member since 2013 · 98 posts · 21 votes11y
Make that GRM. Sorry
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
1. Sorry about that. It's a typo - my projections of real operating costs are a bit under $665,000 - $335 is a typo. Apologies
2. The LOI price is a function of a formula that's based on a discounted capitalized valuation. It uses the stabilized NOI to price out the stabilized valuation, and then applies a discount rate to the CAP (along with a bunch of other stuff) to arrive at an offer.
When money is on the line, rule #1 is - DO NOT LOOSE. It hurts too much :( There are an awful lot of people chasing yield now days - fool's game. I only deal with highly motivated sellers. I am not excited by the privilege of owning property.
This guy is loosing money - I know this because I can read numbers. He hasn't grasped the depth of the hole he is in yet...
Hopefully this answers your question.
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
@Stephen Dominick GRM stans for Gross Rent Multiplier. The metric compares what people are paying for property as per the revenue stream represent by its' Gross Rent. For instance, if the 4-plex brings $24,000 of rent per annum, and someone pays $240,000 for the property, then it can be said that they've paid a price which is a function 10 GRM. If they paid $120,000 for the same property, then the GRM is 5.
Like CAP, this is a metric which is most useful in measuring the marketplace, not a particular property performance. It is indeed very localized metric. But, not a good one since it does not account for the operating costs - the rents are easy to underwrite comparatively speaking. The hard part is to score the operating costs, and the GRM does nothing for that by design :)
Do not use GRM...
- Investor · Brodheadsville, PA · Member since 2013 · 98 posts · 21 votes11y
Thanks for the insight Ben, always very helpful.
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
Originally posted by @Ben Leybovich:
@Stephen Dominick GRM stans for Gross Rent Multiplier.
Like CAP, this is a metric which is most useful in measuring the marketplace, not a particular property performance. It is indeed very localized metric. But, not a good one since it does not account for the operating costs - the rents are easy to underwrite comparatively speaking. The hard part is to score the operating costs, and the GRM does nothing for that by design :)
Do not use GRM...
@Ben Leybovich I have to strongly disagree. GRM's are probably what most posters here should be using to determine market value of possible multi-family investments. All you need are sales prices and rents. Generally sales price are public record or can be obtained through MLS and if you are working an area you should b able to ball park rents. Price divided by rents = GRM! Market GRM times your gross rents =Value. How easy is that? As long as you are using comparable properties your comps should be right on.
I don't see you railing against all the people that come up with crap rates by defining NOI as 50% of gross rents which is suspiciously pretty much a GRM (if ALL properties have the same expenses why do this extra step?) except it results in a percentage which just seems way smarter and then you can compare it to your banks passbook accounts interest rate LOL!
Unless you have the actual components of your NOI comps and the skill to analyze then GRM's will probably be the easiest and most accurate to determine market value.
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
Well, @Account Closed - you can disagree, but you'd be wrong. Example: two 4-plexes around the corner from one another. Both getting $500 x 4 in rents. Both are brick, slate tile pitched roof, basement, replacement windows, hard-woods; both are from the 1920es - I am describing a vanilla building in Ohio, Michigan, Indi, Kentucky, Tennessee, etc...
But, one building has individual gas furnaces - an upgrade as of about 7 years ago, while the other is on a gas boiler, which was original system design.
The GRM analysis would price those the same; why - cause the gross potential incomes are the same. However, the operating cost of a boiler break down to an average of $300/month - that's almost $4k against the NOI. Not only this, but the effective (economic) incomes which account for vacancy, credit loss, concessions, etc will be very different in these buildings as well, since the desirability of one will be much stronger and it will attract better qualified and more economically stable tenants - guess which one it'll be?
I guess in HI it's not necessary to pay attention to little things like that. We, in the Mid-West, loose money pricing our acquisitions via the GRM - the most unintelligent assessment of worth of an income-producing asset.
And I am not sure, Bob, why you would assume that folks reading this are too stupid to underwrite some expenses and comprehend the above 3 paragraphs, are better off using the GRM...
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
Originally posted by @Ben Leybovich:
Well, @Account Closed - you can disagree, but you'd be wrong. Example: two 4-plexes around the corner from one another. Both getting $500 x 4 in rents. Both are brick, slate tile pitched roof, basement, replacement windows, hard-woods; both are from the 1920es - I am describing a vanilla building in Ohio, Michigan, Indi, Kentucky, Tennessee, etc...
But, one building has individual gas furnaces - an upgrade as of about 7 years ago, while the other is on a gas boiler, which was original system design.
The GRM analysis would price those the same; why - cause the gross potential incomes are the same. However, the operating cost of a boiler break down to an average of $300/month - that's almost $4k against the NOI.
You failed to provide an expense for the furnaces.
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
Originally posted by @Ben Leybovich:
And I am not sure, Bob, why you would assume that folks reading this are too stupid to underwrite some expenses and comprehend the above 3 paragraphs, are better off using the GRM...
Stupid is your word. I just described the behavior. If it needed labeling i would say ignorant best fits. Do you really need me to point out the thousands of posts where someone takes 50% of gross rents and calls that NOI. How does that analyze expenses any better than a GRM ? And then they ignorantly utilize that NOI against the subject properties "value" and think they have a cap rate. Maybe you called it right, that is pretty stupid. At least with the GRM the numbers would come from an actual sale.
Join the conversationCreate a free account to reply, vote on answers and follow this thread.