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
I guess I got carried away. I just get short when deals get dressed up to try to make them look good by using a lot of complicated math. The math is fine, but the shakiness of the assumptions gets glossed over. How many investors come here and ask about how they manage to get out of a deal that's eating their lunch? How many times has some one posted "my tenant moved out unexpectedly, and the mortgage payment is coming due, what do I do?" My dad has a retail business and often says "some stuff is made to use, some is made to sell". Same applies here, some deals make a lot of money for the sellers and leave the buyer holding a money pit. With enough lipstick (aka optimistic assumptions and complex analysis), anything can be made to look good.
Nothing wrong with speculation, as long as you realize that's what you're doing. If you're going to speculate, you should certainly have a good basis for that speculation.
Jon, you raise a very valuable point. Everyone who gets involved in real estate should have it tatooed onto a visible body part, where they can refer to it easily:
"Speculating is not the same as investing."
Speculating involves definite high risk with possible high reward, usually over a short time frame. The speculator typically has little or no control over the outcome of his bet.
An investment is an attempt at long-term accumulation of wealth. The reward is likely to be smaller but so is the risk. And with a good income property, you don't have to rely entirely on forces that are out of your control to maximize your return.
This thread started on the subject of cap rates and meandered a bit into commentary on a number of other measures. Let me add my one cent (used to be two, but I had them in the stock market):
I think it's incorrect to label any of these measures or techniques -- cap rate, IRR, DCR, pro-forma analysis, etc. -- as useless or irrelevant. In my opinion, the informed investor understands all of these, and more, and recognizes that they have different purposes and can satisfy different objectives.
For example, on the original subject, cap rates. You may be looking to purchase a small office building, and find two or three candidates in a particular zip code. You also find that the last several properties like these, in this location, sold at cap rates between 8% and 9%. After you reconstruct the owners' representations about the properties for sale (i.e., after you verify the rents and the major operating expenses like taxes and insurance, and apply your own experience about the typical costs to maintain and the amount you need to allow for potential vacancy), you decided that these properties are being offered at something closer to a 5% cap rate.
Before you spend any more time or effort considering these properties, you know that, at their asking prices, they are not worthy competitors for your investment dollar. If comparable properties yielded 8% or more, you feel justified in settling for no less of a return. It is simple math to calculate the price at which each of the properties might begin to make sense. You may decide simply to move on to some other investment that will meet your objectives better.
At the same, you recognize that satisfactory cap rate is not sufficient to make a decision to invest, because cap rate is a measure at a single point in time. You decide that "long term" means at least seven years, so you develop pro forma projections going out seven years: income, expenses, cash flow, potential resale. Crystal ball a little cloudy? Of course, you don't know precisely how these variables will progress over time, but if you can probably make reasonable assumptions based best-case, worst-case and perhaps a few in between scenarios. Things seldom go as well as you hope or as bad as you fear, so the property will probably perform somewhere between the best and worst cases. You may look at a time-weighted measure like IRR. Can you live with performance like what you see between the extremes?
For your re-sale projections, if this is a real income property like an office building, forget the word "appreciation." Income properties don't rise in value because of the passage of time. They rise, if at all, because they produce a greater income stream. The person who buys from you in seven years will do the same kind of analysis you're doing now and will pay accordingly. At what price will the property offer a reasonable return down the road to a new owner?
And do you care about Debt Coverage Ratio? The banks want to know if your NOI is going to be sufficent to cover your debt service, with about a 20% cushion for error. You should be no less concerned. It may sound great that you're using no money of your own, leveraging the property to the limit, but that property's debt may then become a hungry demon.
Different measures, different techniques, different purposes. Don't discard them. I think each can tell you something you need to know to make an intelligent investment decision.
Once again, one shouldn't look at any one particular factor when determining whether or not a property would make a good investment. Cap rates alone shouldn't do it. After all, according to many of the above posters, a multi-unit with a cap rate <7% couldn't possibly be a good deal. Just the same, an "incomprehensible" IRR calculation shouldn't be the sole guideline either for determining whether or not a deal is good or not.
One of the biggest points that seems to be lost in this discussion is how a multi-family property is valued. Unlike single-family residential values which are based solely on the market and, thus, subject to speculation, an investor can increase the value of a multi-family property by increasing income and decreasing expenses. Its a pretty simple concept, but its been lost in this discussion.
Kyle -- You hit it precisely. Income-property investors buy the income stream, not a pile of lumber. I devoted a fairly extensive case study in my latest book trying to show that a single-family house, even if it's held for rental, is a critter that's quite different from a true income property.
You might want to see an article I wrote that is directly relevant to your point about creating value by improving NOI. It's "Managing for Value" at http://www.realdata.com/ls/manofvalue.shtml
As far as the rest of your post, I mostly agree. Much has been lost in this thread. The original question referred to cap rates which have everything to do with commercial properties, which are an entirely different investment than residential units (SFR, duplex, triplex, quadplex) These units are valueated based on comps, not cap rates. Commercial units on the other hand are valued on the cap rate. As it has been mentioned, there are many, many mathematical calculations to utilize, but not one of them, on their own, are determining factors of a decision to purhcase or not to purchase.
I actually agree with Will. Speculating is certainly investing and can be very profitable if things happen as you expect. However, speculating certainly does involve more risk (and often more reward) than other more mundane forms of investing (like the rental market). Those people who bought California real estate in the late 90's and then sold at the peak, made a lot of money. On the other hand, millions of those that bought at the peak (about 2005) and were betting that prices would continue up, are now being foreclosed on!
However, I do disagree about there not being a single calculation that determines whether a commercial property is acceptable. I would argue that cash flow is the determining factor if you are running a traditional rental business. If you're speculating, then all bets are off (or maybe all bets are on).
Mike
I do appreciate everyone's involvement in this thread as it has answered alot of questions I had on the subject..
Thanks!
Dustin
Holy Threads Batman, Mike and Will agree. Astonishing!
Know that I'm done being funny, ha ha ha, I do agree again Mike that cash flow is an indicator to buy or not to buy, but I still don't agree that it can be the ONLY one. For example, what if you hit your cash flow mark, but not your DSCR? You will not get financed. What if you hit cash flow but your cash on cash is only 5%? Wouldn't you rather put that $ to work in a non-risk, non managerial vehicle such as a CD for a similar return?
Cash flow is muy importante for apartment buildings as you buy them for that purpose, the income stream. I just personally feel that there are several deciding factors to determine if you should or should not buy an apartment complex.
If you always buy at a big discount and have the $100 per unit cash flow like I do, this is never an issue. I don't calculate DSCR and have never had a bank say ANYTHING to me about it (although I'm sure that they calculate it). I almost never use any of my own money, so my cash on cash return is infinite. Again, not an issue. I certainly don't calculate IRR as that's just a bunch of guesswork. What I care about is how much equity I'm getting NOW and how much cash flow I will have NOW!
However, I do agree with you that this isn't the only way to make money. Speculating on future appreciation is a valid model, provided of course that you can support the negative cash flow while waiting for the appreciation.
Mike
True, or have minor cash flow with larger appreciation expected from your reasearch in the future. Spec does not necessarily have to equal negative cash flow right Mike.
I see your point that if you are buying at enough of a discount, all the numbers I calculate would have to pencil out. My only thought is that on some investment vehicles, it may not which may get an investor into trouble and therefore it is my personal opinion to go ahead and calculate all the factors to make sure they all pencil.
Will Barnard
"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. "
Hey i have a question about this quote.
"OE/CR (30%) $15,000 (Assumes NNN)"
What does this formula provide you with.
I assume oe means original equity.
What does CR stand for? (cash rev.) and NNN?
What does this formula tell you?
Forgive me for my ignorance. I was taught to ask questions when i didn't know something.
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.
What do you mean by "Have supporting documents with your offer"?
So many people over think this. I like to take a stock valuation analogy and think about it like return on assets vs. cost of debt. The asset needs to generate a return that's higher than the cost of debt in order for it to be a "good" investment. This allows me to look at the market rate of debt, compare it to the Cap rate, and see if I can make money on the deal. If my lender is offering debt at 4% and Cap rate is 6%, I can stop right there and see that I can harvest a 2% spread since my asset is generating a return higher than my cost of debt. Volatility of the Cap rate needs to be factored in to see if the spread is adequate.
If I was renting office space to the US Treasury at 4.25% Cap rate, and all of my expenses were locked in for the next 15 years, I could reap the 0.25% spread over my cost of debt. It's not a huge profit, but it's a safe profit. Now if I had equity (office not 100% financed by debt), I need to make sure that the equity holders are satisfied with the 0.25% spread on the debt + 4.25% on the equity. If you want to get technical, you gross up the levered return to adjust for taxes.
Don't listen to the Cap rate haters. Just learn how to use it and understand how not to use it.
12%. Consider, when there are low risk investments earning that amount, for what reason would an investor tie up in a property earning less than that?
Cap rates are not a joke, a cap rate is important to determine how much the rate of return is, I still like the basic of how much does the property give me in my pocket after expenses. I think if you can get a cap rate of 14 or higher, you are doing well. But keep to the basics, how much are you spending and how much do you get to keep after expenses.
Negotiate the best deal you can and if the cash flow is great and the CAP isn't, you decide what you feel comfortable with.
Also, what if your negotiations with the seller is not calculated into the CAP rate. Suppose the seller will gives you $10,000 at settlement and includes all the furniture and the cars in the garage and gives you a 6 month grace period on the owner financed mortgage, how do you calculator s CAP rate.
I love CAP rates, but I love the other method of calculating my investment return, it's call the "Gut Feeling", do I feel good, am I making money, OK, I'll go for it!
I have been investing before pagers and cell phone came on the market, my gut has always been my determination if I wanted to do the deal or not.....Sorry about you CAP rate lovers.
Go for the Gut!
Charles
Hey Dustin!
For data on current cap rates, here is a resource the shows the current cap rates for apartments in 50 different markets. They try and keep it up to date so it could be helpful: http://apartmentpropertyvaluation.com/
You should never buy a rental property based on projected appreciation neither on cap rates alone.
You need to look at the actual NOI based on the books, and take into account:
- the additional operating expenses that may occure after the transfer
- the vacancy rate
- the improvements quality, age and condition (calculate the replacement or repair costs over the next 20 years)
- the accrued property taxes liability you will have to carry after the transfer
If you take into consideration all these factors, i bet you won't find many properties with positive cash flow after debt collection and taxes