What is your MINIMUM required Capitalization (Cap) Rate?
Specialist · Orange County, CA · Member since 2008 · 2k+ posts · 623 votes
What is your MINIMUM required Capitalization (Cap) Rate?
Most Popular Reply
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
11yThought I put two cents in this thread, guess not.
I agree that Bob is going down the right path. as I mentioned recently in a similar thread comparing stocks to real estate, before your cap rate is viable you need to look at apples and apples, not apples and oranges.
If you take Chapter One of The Principles of Real Estate, you'll see that while real estate in different classes may be similar but no two parcels are identical. That means the risks are not identical. To obtain a fair cap rate you need to look at opportunity costs of alternative investments, being the same or nearly the same, that's very hard to do in real estate.
Your cap rate will never be the same as mine, my actual expenses won't be identical to yours, in fact, mine won't be the same every year. Our cost of money isn't the same, our opportunity costs are not the same, our NOI won't be the same, out tax position won't be the same and forced or market appreciation won't be same same.
A seller tries to sell historical income setting a price. That's like selling me a used car showing your costs to operate it with the maintenance you did or didn't do and then expect me to pay a price based on your past experience, the second hundred thousand miles won't be like the first hundred thousand miles. While this is apples and oranges to real estate, the theory is the same, in assuming my future experience will be like your historical performance.
Lenders and appraisers have more market information than investors and much of that is shared. An appraisal is an opinion of value as of a certain date, it's not the market value until a price as been obtained in an open market transaction. Past transaction show trends, not absolutes. An appraiser will not say the cap rate for this property must be 10%, they are more likely to say that a 10% cap rate is comparable to what other investors obtain for similar properties.
Your cap rate analysis is more of a psychological barrier that a true financial barrier for pro forma assumptions. Picking a number as your cap rate and then adjusting income and expenses to arrive at that number is useless. The market set the income and only actual expenses set operating costs, fine for looking in the rear view mirror once in awhile, but I have to see or understand what's ahead as what is applicable to me in the future to my desired profits.
I do want to see fixed costs of a current owner, some of them will be applicable and other expenses may not be. Current rents only gives me a picture as to the current day and the near future as leases expire. Beyond that I have to look at the market and management expertise to profit.
I consider estimated net operating income, I never consider the owner's cap rate or even try to guess at my future cap rate, it's irrelevant. When buying, consider net income, forced and market appreciation, tax implications, management requirements, debt service and known fixed costs.
If a property isn't a real pain to manage, pays for itself and doesn't eat any hay, has cash flow for operations, doesn't really cost you anything, then it's a good deal!
Cap rates are fine for liquid investments, inventory management, use of funds, allocations to equity, but not to real estate, at least until you get to very large numbers and can accurately identify use of cash and opportunity costs within the market.
But, many like playing with their financial calculators.... LOL! :)
89 Replies
- Rental Property Investor · Closter, NJ · Member since 2015 · 884 posts · 722 votes11y
I agree with @BobBowling. IMHO cap rates are not appropriate for small residential properties. Mainly used for commercial. However experienced investors look at NOI.
- Investor · Gardendale, AL · Member since 2014 · 96 posts · 33 votes11y
Originally posted by @Daniel Chang:
Yes 6% is low, and yet in CA many properties market <6%. Ridiculous! But it is just a MINIMUM in which to screen. From there, I look into the financials. But to me, if the cap is not higher than the interest rate, an investor would be negatively leveraging, not to mention they will not likely qualify for a loan in the 1st place. Hence, I adjust my minimum screen to the interest rate.
@Account Closed
I sense that you really do no like this "cap rate" idea. =D
This is what generally happens. They minimize expenses to market the property at a higher cap to achieve a higher price. They may market at a 7 cap based on NOI. But they will leave things off like cap-ex, vacancies, management fees (if the owner self manages). So the stated NOI is higher than what it actually would be. If the historical vacancy of a property is 10%, but is CURRENTLY 100% leased, then they will use a NOI based on the current situation. So instead of stating $45K as the NOI, they will state $50K. They will then put it on the market at the "market cap" say 7%, in reality inflating the purchase price by 10%. In this case to $714K. However, based on 45K NOI, the cap @ $714K is 6.3%. Hence they "inflated" the cap from 6.3 to 7.
That's what I mean when I say the broker/seller "increases the cap rate". They do this by increasing the NOI (leaving off some expenses that should be calculated in).
Great reply. Awesome information
- Rental Property Investor · Phoenix/Lima, Arizona/OH · Member since 2012 · 4k+ posts · 4k+ votes11y
Marco - I'll take a 5% Cap with projected IRR of 30%. I'll also take a 10% Cap with projected IRR of 30%. Cap rate is a market-driven metric which I use in ways other than capitalization of value...but you knew that :)
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
in my mind cap rate is a wish list.. and totally misunderstood metric by most investors I know what your asking. Most investors buying SFR are really only interested in what the return COC is to start then they can get NOI after they actually have owed it for a while and they confuse that with cap rate. I hear it all the time hey my property is a 10 cap when in fact its just returning 10% on the invested capital.
@Account Closed
Like Anish Alludes to every year is different every property is different.. and if you have a multi unit your performance is more consistent good or bad because of same location same tenant base and construction methods etc etc. And in most case you have 2 years of tax returns and books to back it up and analysis the asset.. as long as landlord is not cooking the books...
When your talking about what are your turn key clients looking for in return.. I hear from folks they want 10 to 15% and what they really want is if they put 20k down and all expenses come out of rent IE they don't have to feed the property ... they want 2 to 3k net. per door or property.
So in realty with all Turnkey unless you selling homes that have tenants in them and have been in them for 2 or more years you have no history.. its all educated guess on what the return will be.. As no two properties will function and perform the same.. WE all know this... So its nice to look at Performa's but they are meaningless on a property just coming out of rehab and being put on the rental market ..
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes11y
Thought I put two cents in this thread, guess not.
I agree that Bob is going down the right path. as I mentioned recently in a similar thread comparing stocks to real estate, before your cap rate is viable you need to look at apples and apples, not apples and oranges.
If you take Chapter One of The Principles of Real Estate, you'll see that while real estate in different classes may be similar but no two parcels are identical. That means the risks are not identical. To obtain a fair cap rate you need to look at opportunity costs of alternative investments, being the same or nearly the same, that's very hard to do in real estate.
Your cap rate will never be the same as mine, my actual expenses won't be identical to yours, in fact, mine won't be the same every year. Our cost of money isn't the same, our opportunity costs are not the same, our NOI won't be the same, out tax position won't be the same and forced or market appreciation won't be same same.
A seller tries to sell historical income setting a price. That's like selling me a used car showing your costs to operate it with the maintenance you did or didn't do and then expect me to pay a price based on your past experience, the second hundred thousand miles won't be like the first hundred thousand miles. While this is apples and oranges to real estate, the theory is the same, in assuming my future experience will be like your historical performance.
Lenders and appraisers have more market information than investors and much of that is shared. An appraisal is an opinion of value as of a certain date, it's not the market value until a price as been obtained in an open market transaction. Past transaction show trends, not absolutes. An appraiser will not say the cap rate for this property must be 10%, they are more likely to say that a 10% cap rate is comparable to what other investors obtain for similar properties.
Your cap rate analysis is more of a psychological barrier that a true financial barrier for pro forma assumptions. Picking a number as your cap rate and then adjusting income and expenses to arrive at that number is useless. The market set the income and only actual expenses set operating costs, fine for looking in the rear view mirror once in awhile, but I have to see or understand what's ahead as what is applicable to me in the future to my desired profits.
I do want to see fixed costs of a current owner, some of them will be applicable and other expenses may not be. Current rents only gives me a picture as to the current day and the near future as leases expire. Beyond that I have to look at the market and management expertise to profit.
I consider estimated net operating income, I never consider the owner's cap rate or even try to guess at my future cap rate, it's irrelevant. When buying, consider net income, forced and market appreciation, tax implications, management requirements, debt service and known fixed costs.
If a property isn't a real pain to manage, pays for itself and doesn't eat any hay, has cash flow for operations, doesn't really cost you anything, then it's a good deal!
Cap rates are fine for liquid investments, inventory management, use of funds, allocations to equity, but not to real estate, at least until you get to very large numbers and can accurately identify use of cash and opportunity costs within the market.
But, many like playing with their financial calculators.... LOL! :)
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
Maybe GRM is a better way to back into value with turn key rentals.
Since rents are pretty standard in most markets and don't fluctuate much.. and since the homes can be bought for wildly different numbers IE what a wholesaler pays by the time its gone through rehab and mark up for profits for all involved the number is much higher than an Identical property that say a local bought and did it all them selves.
and since in most turn key areas at least sub 80k or so retail sales are far and few between.. I see this in appraisals were they will pick up a few retail sales and try to comp them with those.. but generally those retail sales are the cleanest of the clean in the given area.. IE someone lived in the home as owner occ and really kept it in tip top shape.. rental rehabs are usually not to those standards some can get close ...
So if we had GRM with a given rental rate does not matter the home its only value is based on the rent it will command. I have seen apprasiser use this to substantiate turn key apprasials.
- 11yMike D'ArrigoPro MemberTurn key provider · San Jose, CA · Member since 2010 · 4k+ posts · 3k+ votes
I think @Jay Hinrichs is dead on. A pro forma is simply an overall average for a portfolio of properties of a given class over time. Tenants will always be the biggest variable and a pro forma can't predict a tenant.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes11y
@Jay Hinrichsundefined
The Gross Rent Multiplier is a way to compare similar properties and is a much easier approach, divide the FMV or price by the annualized gross rental income. Some think this tells you the time required for an investment to pay for itself, paying it off and getting your money back. That isn't accurate. It is also thought that the lower the GRM the better the investment apples to apples it is, but in reality it's more like a Ozark yellow apple and a n Oregon red apple, close, but not the same.
But, the GRM doesn't really tell you anything, other than comparing to another like investment and then that may be misleading.
Ratio analysis in RE doesn't take into account tax effects to an individual investor, what the value of having depreciation or other expenses in operations might be. Not included are any assumptions of appreciation, or of market rents increasing over longer periods where the asset is planned to be held, the estimated holding period. There is nothing addressing the equity gained or benefits from having someone else payoff your debt.
Jay, I understand you deal in turnkey stuff, but that was almost a pitch, LOL, common sense tells me the fewer people standing in the chow line, the more likely it will be for the last guy in line to have more to eat. Not saying all turnkey deals are bad, but there needs to be more fat on the bone for all contributing, some wholesaler, a rehab guy, buying and selling costs, holding expenses, profits for all and then had that end buyer the tab for that dinner. It costs a heck of a lot less for a buyer who knows what they are doing to eat alone. An no, a wholesaler doesn't really find a better deal than I can, there is a limit to how low they go.
And, I said, a buyer who knows what they are doing, so many don't. Turnkeys have other buyers as well, investors who look for passive income, who may not enter the buy and hold in their market, they may be out priced, local inventories might be tight and there will be those lacking rehab skills and knowledge to contract with those who can do the job. It can just be an easier way out, but the easy way always costs you. But, I can't agree to those assumptions.
The best ratio for real estate is the MIRR, manager's internal rate of return. The IRR assumes that cash flow is reinvested at the same rate used for the IRR calculation, when in the reality of real estate, it is not. The MIRR is a better economic approach as the reinvestment may be at different rates, like a CD rate or totally ignored as not being reinvested. You can arrive at present values of future expenses, considering increased costs, increases in taxes or rates of estimated appreciation and discounting cash flows. You can also factor in negative cash flows, losses and plug in different timing aspects, say a vacancy for a vacation rental in December and January, and have increases in your proforma during summer months when you know you'll be fully occupied.
Running accurate MIRR values using the same rate variables for different properties will give you the better investment picture of 2 or more alternatives.
Another good ratio for quick analysis is the Debt Coverage Ratio (DCR) used by lenders. NOI divided by the required annual debt service (not including escrows). It shows the available cash flow to service the debt, a ratio of 1.25 means the project returns 25% more than is necessary to pay the debt service. Use this together with a cash on cash ratio and what you're likely able to walk away with will be clearer.
Net operating income is a must to account for, residential rentals for small transactions should go out 3 years, small multi-family might go 5 years, larger projects to 7 to 10 years or over the anticipated holding period. 20 year projections or longer are not uncommon. So, the size and scope of the project determines much of the forecasting requirements.
As I mentioned above, those aspects I mentioned need to be considered, there is no easy plug-in ratio that gives an investor a clear buy or sell answer. It has to be done on a case by case basis, junior high math is involved, the use of a financial calculator is needed, the functions of present and future value needs to be understood. Actually, economics has more to play on real estate decisions that does basic finance, which is included in economic assumptions.
I guess this is just long post day for me.....LOL :)
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
thanks Bill I teed it up so you could knock it out of the park.
DCR is a critical number .... and because as a lender we are not really privy to the bottom line for an investor.. its the best metric we can use to decide if we want to fund a deal..
I think what Marco was trying to get to .. is what will entice a buyer to buy a turn key were do I need to be on return.. and since they all confuse cap rate with rate of return on invested capital.. the numbers I hear form buyers is they want 10% or better.
And on paper that's easy to show with profoma's that can be manipulated any number of ways.. and as you point out and I point out and Anish pointed out you will never know what return you make until you have owned these things for 3 years plus.. because with SFR you can't really predict the future as well as you can with a larger multi or commercial building.
I mean you can buy a dollar General for 1.5 million and have a 20 year NNN lease that's pretty easy to figure out.... :)
- Investor · Atlanta, GA · Member since 2014 · 415 posts · 299 votes11y
7.5%, and only for comparative/elimination purposes; and then only if the Seller hasn't fabricated their NOI (e.g. indicating expenses less than 40%-45% gross rents.) To my way of thinking and analysis, DSCR is a better tool to do a quick and dirty check to see if further, deeper analysis is warranted. I calculate 75% LTV of asking price and then what the annual p&i would be on that amount. Then calculate NOI using expenses at 40-45% gross rents. If NOI/annual debt service is less than 1.2, no go; if greater, analyze deeper.
- Specialist · Orange County, CA · Member since 2008 · 2k+ posts · 623 votes11y
Originally posted by @Ben Leybovich:
Marco - I'll take a 5% Cap with projected IRR of 30%. I'll also take a 10% Cap with projected IRR of 30%. Cap rate is a market-driven metric which I use in ways other than capitalization of value...but you knew that :)
Love you Ben! ;-)
I'm glad to see the debate this thread has created, even though it wasn't my original intent... It was supposed to be a simply poll question.
- Investor · Houston, TX · Member since 2014 · 128 posts · 87 votes11y
Originally posted by @Marco Santarelli:
Originally posted by @Ben Leybovich:
Marco - I'll take a 5% Cap with projected IRR of 30%. I'll also take a 10% Cap with projected IRR of 30%. Cap rate is a market-driven metric which I use in ways other than capitalization of value...but you knew that :)
Love you Ben! ;-)
I'm glad to see the debate this thread has created, even though it wasn't my original intent... It was supposed to be a simply poll question.
Hi Marco
I will answer your question as a turnkey investor. When taking the risk of investing out of state in turnkey properties, I look for 9-13% cap rates. However, I don't assume that the numbers going in to the advertised cap rate are accurate. We break the numbers down into the components and evaluate each number and recalculate our own cap rate. Our biggest goal is to get reasonable cash flow on any turnkey property.
I just talked to Michael in your company about Turnkeys in Brimingham and Houston. In Birmingham I would expect 11-13%. The market in Houston is different. We would be investing here to have properties near home and I would look for 7-8% cap rate. I believe Birmingham would cash flow. I am less confident about Houston, since we are just starting to look at those numbers.
- Specialist · Orange County, CA · Member since 2008 · 2k+ posts · 623 votes11y
Originally posted by @Ann Howell:
Hi Marco,I will answer your question as a turnkey investor. When taking the risk of investing out of state in turnkey properties, I look for 9-13% cap rates. However, I don't assume that the numbers going in to the advertised cap rate are accurate. We break the numbers down into the components and evaluate each number and recalculate our own cap rate. Our biggest goal is to get reasonable cash flow on any turnkey property.
I just talked to Michael in your company about Turnkeys in Brimingham and Houston. In Birmingham I would expect 11-13%. The market in Houston is different. We would be investing here to have properties near home and I would look for 7-8% cap rate. I believe Birmingham would cash flow. I am less confident about Houston, since we are just starting to look at those numbers.
Hi Ann -- thanks for taking the time to answer the question.
Your range of 9 to 13% is very realistic and clearly attractive. It is wise not to take numbers at their face value. As I say, trust but verify.
Your point about the biggest goal being that of getting "reasonable cash flow" is great. Cash flow is the "glue" that keeps your deal together and allows you to control the property. We find too many investors put appreciation as their number one criteria whereas I believe it should be at least third down the list.
Your point about markets being different is spot on. Houston is considerably different than Birmingham Alabama. All other factors being equal you should not expect the same rates of return between those two markets.
As a side, the detailed cash flow analysis tool (the orange button) on our website allows you to see all the expenses itemized and allows you to change them to create your own scenarios. Although we plug the actual current income and expenses of each property there, we double check and confirm those numbers before any property goes under contract with a client.
Continued success!
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
Marco, i don't know if you missed this earlier post thru all the back and forth.
Marco
I looked at your Blue Heron property. You have a cap rate of 9.6% Your potential gross income is only $13,300. At 9.6% you are coming up with a NOI of $10,656. That ONLY leaves $2544 for operating expenses and vacancy and collections. Can you itemize your operating expenses and give your number for v/c?
And property taxes of only $864 seems about only half if not more that what the actual should be. Are you using an owner occupied tax rate for an investment property?
Now I am 100% sure that you have NOT included ALL operating expenses so you do NOT have a cap rate. I call these Crap rates. The benefit of market cap rates ONLY works if all participants in the market utilize the exact same methodology in their computations. See all the different computing crap rates from different investors? Maybe this is something where BP or @Jay Hinrichs can become the PWC/Korpacz of Turnkey/duplex/triplex/fourplex cap rates for the different markets.
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
@Account Closed
Far above my pay grade Bob... I am a really simple investor.. and don't really get into the details of all this stuff.. I just make sure I make more than I spend..
My CFO will spend 30 explaining why we are accounting a certain way I just look at the statement and say fine we made 50k on that one I bet ... and I am usually within a few thousands so that's all I need.
- Real Estate Broker · Mount Olive, IL · Member since 2013 · 1k+ posts · 310 votes11y
Welcome to BP.
Boy, you had asked a very good question and some of the answers / posts are irrelevant (in my opinion).
It's true that cap rates are market driven, however your question comes from a different angle.
My simple answer is 8% and there are a lot of calculation behind it. It's NOT some randomly pick number. Remember real estate investing is a numbers game.
Hope it helps.
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
Originally posted by @Jay Hinrichs:
@Account Closed
Far above my pay grade Bob... I am a really simple investor.. and don't really get into the details of all this stuff.. I just make sure I make more than I spend..
My CFO will spend 30 explaining why we are accounting a certain way I just look at the statement and say fine we made 50k on that one I bet ... and I am usually within a few thousands so that's all I need.
Investing for simplicity AND profitability? Dang if I wasn't so lazy I could make a Guru living off that! It's a hard knock life.
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
@Account Closed
got to stop and smell the roses.. but its a little silly to get all wrapped up and try to get down to the penny on low end rental stock.. there is either some money left over or there is not .. and what determines that is if your tenant has been kind to you... end of story on that one.
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
Originally posted by @James Syed:
It's true that cap rates are market driven, however your question comes from a different angle.
My simple answer is 8% and there are a lot of calculation behind it. It's NOT some randomly pick number. Remember real estate investing is a numbers game.
Hope it helps.
OK so how does 8% help another investor if we don't know your market or for what type of property? Also how can we assume you know how to calculate a cap rate and if you actually have a market cap rate comp to compare your cap rate to.
See, if you are happy with 8% but the market is paying 10% for the same NOI then you are over paying.
- Specialist · Orange County, CA · Member since 2008 · 2k+ posts · 623 votes11y
Hey @James Syed:
You're right - many posts here are irrelevant!
Good answer though. You've defined a criteria that you can measure by. Nice.
Real estate really is a "numbers game".
Continued success!
- Investor · Honolulu, HI · Member since 2013 · 3k+ posts · 1k+ votes11y
So let's run some numbers on a Turnkey SFR. What's the highest NOI I could expect. Let's get crazy and call it $500 a month. So at a 10% cap I should be paying no more than $60,000. Now how much am I going to pay someone to give me accurate cap rate comps of say 11%? Whee, now I know I'm overpaying by a little over $5,000...if the comps are good. I don't think the market would pay enough for someoe to make a profit doing this. Maybe if you outsourced it ti India. ;-)
- 11yJay HinrichsBusiness MemberReal Estate Consultant · Summerlin, NV · Member since 2014 · 45k+ posts · 66k+ votes
@Account Closed
I just closed a deal In PA and they did outsource the escrow to India.. it was frustrating to say the least.. the title and escrow company was in Atlanta and all comm was with indian folks ...... it was pretty funny actually ... I can't believe they are doing this.
- Rental Property Investor · La Quinta, CA · Member since 2014 · 1k+ posts · 779 votes11y
I'm looking at significant modifications and improvements to the properties I am purchasing. As such the existing CAP rate is fairly meaningless -- as is future CAP rate, given the denominator (the asset value continues to change over time).
Right now I am looking for NOI / Total property cost (purchase plus rehab and related) to be 20% the second operating year. I.E. if a buy a place for $700k, and spend 6 months and $300k improving and changing it (so $1mil total cost), I want to see $200k in NOI the second full operating year (months 18-30 in this case, since the rehab took 6 months). This gives me time to get the place leased up and iron out the kinks to determine ballpark what steady-state NOI is.
If I achieve that, and market CAP rates are 6-7% or so, I should be able to sell the asset for 3x what I put into it. And those are the wins I am looking for, cost of $1mil, sell for $3mil about 3 years later.
- Real Estate Professional · New York City, NY · Member since 2015 · 55 posts · 14 votes11y
Originally posted by @Marco Santarelli:
Although I'm not a big fan of using the Capitalization (Cap) Rate to analyze a property, it is a number used by many investors as a quick one-dimensional metric. It is also one that is more commonly used in the commercial space.
Of course, investors have different subjective expectations of what a "good" or "minimum" cap rate is.
So I'm doing a quick poll via this post:
What is your MINIMUM required Capitalization (Cap) Rate?
Hi Marco,
I'd say it depends on the market relative to the area in question and carrying capacity of your dollar. NYC residential condos are about 3-4% if you're lucky, and while this number is a lot lower than a 10-15% expected average mostly everywhere else, the appreciation and demand is incredibly high. Let me know if you have any clients looking to buy or sell in New York City; I'd be glad to work collaboratively.
Best,
Barry
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