What Do you consider a good Cap rate?
Investor · Clarksville, TN · Member since 2008 · 122 posts · 53 votes
I read in a thread concerning California where multi unit residentials are selling around 4-5%.. which lead me to a good question.. As investors from across the country, what do you consider to be a good cap rate? Being realistic.. what do you look for in a rate of return per annum? Talking about multi unit residentials. Thanks ahead to anyone who responds.
Dustin
Forget the cap rates - they are a big joke except for very large commercial buildings (and even then they are usually a big joke). Cap rate is defined as NOI divided by the purchase price. To determine the NOI, you need to know the operating expenses. Therefore, to determine a market cap rate, you need to know the operating expenses for the area. That information simply does not exist and many (most) investors don't understand operating expenses themselves, let alone have accurate records for their property.
Finally, the vast majority of newbies fail in this business and the majority of rentals in the US are owned by individuals. So, even if you could get an accurate market cap rate, it would only tell you what the losers paid for their property!
My suggestion is to look at each individual property and see if it will cash flow. You can't eat cap rate, but you can eat with CASH!
Mike
Forget the cap rates - they are a big joke except for very large commercial buildings (and even then they are usually a big joke). Cap rate is defined as NOI divided by the purchase price. To determine the NOI, you need to know the operating expenses. Therefore, to determine a market cap rate, you need to know the operating expenses for the area. That information simply does not exist and many (most) investors don't understand operating expenses themselves, let alone have accurate records for their property.
Finally, the vast majority of newbies fail in this business and the majority of rentals in the US are owned by individuals. So, even if you could get an accurate market cap rate, it would only tell you what the losers paid for their property!
My suggestion is to look at each individual property and see if it will cash flow. You can't eat cap rate, but you can eat with CASH!
Mike
Once again , Mike is right....
If you use the 2% rule, and went with what most people put under the "Cap Rate" Section of the MLS , you'd need a 24% cap rate for the property.
Most commercial brokers will tell you, don't look at cap rates!
The way that large companies determine value of a property and returns is to look at the actual income vs expenses for the property.
If I figured out the return rate with all my rentals, on the cash invested portion , I'd be around 18% return or so, which is low becuase I've made PLENTY of mistakes this year due to learning the business.
1. Learn your market! Find out what the rental rates are (If you're looking at multi family).
2. Learn the going rents in your area! Next time you're out, grab a penny saver, then go to craigslist and fine out what properties are renting for.
3. Find out what the norm is in your area, and then work a plan to buy it at HALF of what everyone else does. This is the way WINNERS win the game, loosers buy at market value most of the time and proceed to loose their money.
If you could make $1000 a month, or loose $100 a month, which would you prefer? Many people seem to have it in their head it's better to loose $100 a month in the HOPE that the property appreciates. We've lost about 40% of real estate investors over the last 3 years from this GIMMICK of appreciation, yes, there is appreciation but you can't hedge your bets on it.
Hedge your bets on a good return (Leveraged returns using the 2%/50% rule should return 40%+ per year on a 25% LTV loan).
Dustin - Cap rates, like politics, are very much a local phenomenon. The prevailing cap rates may differ from one part of a city to another, and from one type of property to another.
The purpose of a cap rate is to express the relationship between an income-property's NOI and its value. So if you do your homework and have a good idea of what the prevailing cap rate is for a particular type of income property in the subject's location, you can make a reasonable estimate of it's value.
That's not really enough to make an informed decision to buy, however. Assuming you plan to buy and hold, you also want want to make cash flow and resale projections going out several years -- I would say five at the least, but probably more.
If you go to my blog page here on biggerpockets (or the blog on my company's site) you can download a sample chapter from my latest book -- the chapter is about using cap rates.
As Frank mentioned, Cap rates vary from city to city, and even from neighborhood to neighborhood. However, I certainly wouldn't say that cap rates are a big joke.
To utilize cap rates in your favor, you have to really understand cap rates and the market in which you wish to invest. That takes more than just leg work; it takes experience investing within a certain market. Therefore, if you come across a gem in Southern California selling at a 7% cap rate and you know the market is around 5.15%, you're looking at a deal right off the bat.
Of course, I'm not saying look at cap rates to evaluate a property. It's still all about expenses and income. Look for those poorly managed properties that you can turn around... and if you can get the property at a favorable cap rate, all the better.
Thank you guys!
I'm totally with Mike on this. All investments must have positive cash flow to be an investment. If you expenses are higher than the income after all tax breaks, etc the property is not a sound investment. Look for high discounted properties and don't be shy with your offers that support a positive cash flow. Have supporting documents with your offer.
I have some clients of mine looking at a 2006 built retail center in the Central Valley of CA, fully leased with NNN tenants on 4-20 year leases with a cap at 6%. This thing would've sold at about 4.5 - 5% a couple of years ago. Everyone around here is still asking 7-8% on retail centers, pro-forma of course.
Of course proforma means nothing, right John!
The def of cap rate has already been explained here, so I will not reiterate.
Mike made a point that a 6 or 7 cap does not cash flow, it only bleeds cash. If you are getting a positive cap rate, you are making money, since the OE has already been deducted and the NOI is your cash flow (not taking into consideration debt servicing). This is they key to the actual true cash flow Mike is pointing out, and a 6 cap, will most likely not get you there.
Example:
$500,000 ask price
Gross income $50,000
OE/CR (30%) $15,000 (Assumes NNN)
-------------------------------------
NOI = $35,000 (7% Cap to ask price)
Debt Servicing $40,512 (25 year ammort. @ 6.5%)
Net Cash flow = ($5512) annually
Hence no cash flow.
Please show us how a 6 or 7 cap does cash flow.
That was my point, proforma = bs in my book.
The places I've looked at in Wyoming have been in the 7.5-10 range. While that may seem awesome compared to what I have heard about in the rest of the country they still carry significant vacancy % and rental income risk. Unfortunately my pockets aren't always deep enough to come up with the 20% down. Still this should give you another perspective. As with anything cap rate related, whether it cash flows or not depends entirely on how much a person puts into the down pmt.
Dustin,
Cap rates are one stochastic used by professional investors to compare one investment option against another...either in the same asset class or across classes.
After all how do you know if you if you should by a 4 unit rental property with your investment dollars or buy another unit across town...or better yet, put your money in another "type" of investment altogether.
The argument that one can never really "know" the expenses on his investments which then nullifies the value of cap rate calculation is patently ridiculous.
It's our job as investors to know all the costs associated with our investments to get the true ROR, and if that's a "tough" job during the due diliegence phase of buying a real estate investment...so be it. It still must be done.
That said, we then go forward to calculate the cap rate...an accurate number we can use for comparison.
In graduate school, one of the "givens" in multi-unit real estate analysis problems was the investors tax rate and their "anticipated rate of return"....or put another way...their opportunity cost rate. What I often referred to as the "I can do better over here" rate.
So once one did the cap rate, the pre-tax internal rate of return, and after tax internal rate of return...you could accurately decide if your investor should buy your RE investment or stick with his "better option over there".
BTW in terms of making investing decisions, the after-tax internal rate of return on real estate is the stochastic to use....not cap rates....it's just a better measure of what your really need to know...."Will I make money here?"
With all that said, the cap rate kicked around as "good" on mulit-unit residential rental properties...is between 10-12% per year. This is supposedly the thereshold where even stock market investors get interested in the real estate market.
BTW, every number you need (including expense figures) to determine if a property is a money maker is within reach, it only takes a little digging.
Don't listen to all the hyperbole here about what you "can't" do or what investors "never" do....you are an individual....and it's what YOU do that matters. :D
Good Luck!
You should never have to buy cash flow, especially in this market. Look for a good deal and put down as little as you can. Use the money you were going to buy the cash flow on the bad deal and put it towards a second good deal.
Rob,
I feel for you. That post of yours is destin to get hammered by Mr Ohio.
At any rate, I agree with you. Internal rates of return are vital calculations in determining to move forward or walk away from an investment opp.
Cap rates are not usless, but there are just one of many calculations needed to making a decision on an investment.
This line is the best:
"Don't listen to all the hyperbole here about what you "can't" do or what investors "never" do....you are an individual....and it's what YOU do that matters."
EXACTLY!
We often make offers contingent on $X amount of yearly NOI. If the seller cannot prove that NOI in diligence we have an out.
But really people should be buying properties with the best TRUE cap rate, if you buy right you will have positive cash flow.
Mike - can you explain how someone would determine what a property would cashflow without first getting to the estimated NOI? Short of a property having assumable financing, what the existing owner cashflows is not what a new buyer will cashflow.
For property comparison and pricing purposes a cap rate is a much better tool in my opinion. But positive cashflow must exist...
I used to wonder why anyone brought properties in California and New York with their low cap rates compared to markets like Ohio.
But over the past 10-20 years, you would most likely make more money buying and holding a property in Lower NY rather than buying and holding a property in, say, Cincinnati, OH. Here's one of many examples of property that a relative of mine purchased in Queens, NY:
Purchase Price: $360,000 (Year 2000)
Rents: $4,500 in 2000, Now $5,200 a month
Expenses approx $1,700 a month
The cap rate is low compared to that of a property in Ohio, but that property has appreciated to $800,000 today, and the in the Queens market, it can sell for close to $800,000 quickly.
The whole block has 5 of these houses built by the same developer in 1989. Each of the houses was built and sold for $100,000 in 1989. Someone brought their neighbors house in 2006 for $600,000, (same house basically) and just sold it for $800,000 last month.
Now I can't predict the future, I don't know if NY can still appreciate the way it has been for the past two decades. All I know is that a lot of millionaires were created (personally that I know) from buying and holding over a period of a few years.
To cash flow with multi-units in So Cal at those low cap rates, it takes quite a bit of cash down. The cash flow is nice as its the lubrication that makes any business run smoothly. But, as Rob said, as far as real estate investing goes, you have to look at the property's internal rate of return! And that's why, despite the low cap rates, people continue to invest in Southern California.
C'mon. You don't need to dress up a deal with an incomprehensible IRR calculation. Or, try to "put in a big down payment to make it cash flow". If something has a true cap rate of 7% and you buy it even with all cash, you're not buying for the cash flow. You're speculating on appreciation. You can calculate an IRR or some such BS but you have to guess at the future appreciation. My guess is that appreciation in SoCal (or NorCal, or LV, or NY, or FL) is going to be negative for years to come. Woo whah, lose money every month, lose when you sell.
Why do people buy these deals. They're idiots or they're delusional. Either they're caught up in the hype that "real estate always increases in value" or they honestly believe that. Look at the long term Case Shiller inflation adjusted data. If you take out inflation, real estate prices are FLAT from the late 40's until the easy-money-induced-bubble we're still working off. There have been many short term ups and downs in that period. But the overall trend is flat.
Do people get rich holding RE, even in these areas? Yes. Why? Leverage. You can lock into a loan and let the inflation driven appreciation occur over the long term. But you better be in a position to either put money in each month or have a truly cash flow positive deal.
Jon Holdman, I partly agree with you. However, I know that in the year 2000, you could buy houses in Queens and Brooklyn, NY with small but positive cashflow. Now, it's nearly impossible to buy positive cashflow with 20% down. However, real estate prices are up dramatically since 2000. Here are two actual examples of a relative of mine:
1998, My uncle purchased a single family (only house on the block, and it was zone commercial and residential). Price was $128,000, with $10,000 cashflow/year. Two years ago, developers offered $700,000, he refused. Today, it is worth $850,000.
Another example: 2000, purchased two family for $360,000 and sold for $880,000 earlier this year, has $10,000k positive cashflow in 2000
However, if they brought the houses now, no way would they have positive cashflow. I'm not even sure how to invest in that kind of market now.
Agree, real estate prices ARE up dramatically since 2000. Dramatically as in that's NEVER happened in the last 100+ years. The period from about 1998 until about 2006 or early 2007 saw appreciation that has never been seen before. That was driven, IMHO, by 1) the huge outflow of money from the stock market after the dot com crash, and 2) the very loose lending environment. That sent demand through the roof, and since supply could only expand so fast, prices rose dramatically. Now lending is much tighter. So, again IMHO, prices will eventually drop back to their long term, inflation driven trend. We're already seeing prices fall in many areas, and I think we have more pain to come. If inflation is high, the trend line will catch up faster than if inflation is low or if we actually fall into a deflationary period. My guess is that the property you describe will never again in my lifetime (I'll be 50 soon) trade hands at that price.
I know how to invest in that environment, but I've never figured out how to short sell houses.
All that said, there are many places that didn't see the dramatic increases, and so don't have as far to fall. Those places may see a return to the slow, long-term appreciation we saw in the past. And, there are always specific local drives, such as new jobs or new transportation, that will drive conditions in very specific areas.
Well, that is certainly telling it like it is!!! Not very politically correct, but certainly the truth!
Mike
Thanks everyone!!