What is your MINIMUM required Capitalization (Cap) Rate?
Specialist · Orange County, CA · Member since 2008 · 2k+ posts · 623 votes
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?
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! :)
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.
Yep, New York City is very expensive with very low cap rates relatively speaking. Real estate investors have benefited greatly in many of the coastal markets on both sides of the U.S. largely because of rapid appreciation rates. Unfortunately it doesn't go on forever as these are cyclical markets. Getting in at the right time with positive cash flow is the key. Chasing appreciation is a speculators game as you don't know how long it will last. An investment has to make financial sense the day you buy it.
I'd be happy to send clients your way if we can't help them. Thanks for posting.
Continued success!
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.
Yep, New York City is very expensive with very low cap rates relatively speaking. Real estate investors have benefited greatly in many of the coastal markets on both sides of the U.S. largely because of rapid appreciation rates. Unfortunately it doesn't go on forever as these are cyclical markets. Getting in at the right time with positive cash flow is the key. Chasing appreciation is a speculators game as you don't know how long it will last. An investment has to make financial sense the day you buy it.
I'd be happy to send clients your way if we can't help them. Thanks for posting.
Continued success!
Thanks Marco- happy to refer you clients, as well. Send me an email so we can discuss! [email protected]
Best,
Barry
The last property I bought has a cap rate of zere. Or negative. However, I expect to be able to sell it for twice what I bought it for after I add some value.
Nice Jon! Forced appreciation through value-added renovations is a good strategy. Good luck.
Yes, I have calculated;
insurance
property taxes
maintenance & repairs
property management
reserves
lawn care / snow removal
advertising
common utilities
misc cost
and have done this so many times in my farm area that now I could comfortably say that if I am getting an at least 8% cap rate, I will be safe.
Besides cap rate, I also look at other parameters, for instance;
GRM
Price Per Unit
ARV
Expense Ratio
15 Year Mortgage Rule
And the list goes on.
Hope it further clarifies.
(I assert we are NOT claiming that there is one cap rate that applies everywhere, however cap rate of 8-12 is used by most investors).
By the way, there is an excellent book on numbers called "what every real estate investor needs to know about cash flow" and is written by Frank Gallinelli. I also use his cash flow spreadsheet software called "PRO APOD". Very good stuff.
I mentioned all this because I have read over 250 books on real estate & that is one of the best books out there about real estate investing numbers. And YES, I borrowed most of the books from variety of libraries, but do own quite a few books.
And last biggerpockets is the platform which has really boost my confidence.
Keep learning.
I mentioned all this because I have read over 250 books on real estate & that is one of the best books out there about real estate investing numbers. And YES, I borrowed most of the books from variety of libraries, but do own quite a few books.
And last biggerpockets is the platform which has really boost my confidence.
Keep learning.
You are a reading rock-star James! :-)
Frank Gallinelli's book is awesome. I remember reading it back in 2004 on a flight to Detroit. Couldn't put it down.
I'd like to get Frank on my podcast. He would be a great guest on the subject.
I covered the APOD on episode #005.
Continued success!
Speaking of Frank, here's some of his comments on market cap rates.
Cap rates are essentially a market-driven metric — a market cap rate represents the rate of return that investors in a particular location are actually achieving with a certain property type (office retail, etc.). As such, you really can’t describe a rate as being high or low universally. A 9% cap rate on a particular property might seem very high to an investor in midtown Manhattan, while the same rate could seem very low to someone in Upper Dry-Rot County.
I don’t want to invent any new terminology (we have enough already) but perhaps a way to wrap your mind around this is to start by recognizing that the market cap rate is, as I said, the rate of return other investors are actually achieving for a given property type in this location. Then, when looking at a particular property, calculate its cap rate and ask, “Is this property yielding a market cap rate, an above-market rate or a below-market rate?” I think describing a property as being above or below the market rate will tell you more than describing it as having a high or a low rate.
When I started investing in midwest "turnkeys" my simple criteria was that the rents should be able to pay the mortgage off in 10 years with no more than 25% down and after all expenses. So far after 3 years data on a portfolio of 8 homes I am so far on track. But out of the 8 homes, YTD one is negative $1200, one is exactly break even, and others are around $1000-$1200 positive after all expenses and a 10 year amortized mortgage payment. If I owned only any one of those, my cap rates or ROI or IRR would be wildly different for the year. And one long vacancy or bad tenant can throw the numbers around dramatically. Thats why you cannot assume any kind of performance on a single SFR, especially in the low rent midwest/south. Only having a portfolio allows you to smooth out the returns.
how about 4 % higher than what I can borrow at.
@Account Closed et al.
I agree that cap rates are market indicators. It's like saying the typical house in a typical neighborhood sells for X then make adjustments for all comparables based on that. If you want this house to be $150K when it's $200K, you are in the wrong market.
That being said, to say the calculation of NOI/Price is not a useful number in comparing apples to apples is crazy. I had a client last month deciding between a 1950's 4-Plex, a 2005 duplex, and a 1970's 8-Plex. Two of the properties were professionally managed, so the numbers were more believable. But this calculation was very important in our analysis. GRM misses the maintenance, and IRR assumes a sale. I have not worked with MIRR (thanks for the tip, @Bill Gulley)
Perhaps we can call it "capitalization ratio" instead of "rate" when used for these purposes?
That being said, I can't recall ever seeing a true double-digit residential "as-is" property (with accurate capex and maintenance calculations) that I would buy and hold for 10-30 years. But my CoC is much higher.
@Account Closed et al.
..........That being said, to say the calculation of NOI/Price is not a useful number in comparing apples to apples is crazy. I had a client last month deciding between a 1950's 4-Plex, a 2005 duplex, and a 1970's 8-Plex. Two of the properties were professionally managed, so the numbers were more believable. But this calculation was very important in our analysis. GRM misses the maintenance, and IRR assumes a sale. I have not worked with MIRR (thanks for the tip, @Bill Gulley)
Perhaps we can call it "capitalization ratio" instead of "rate" when used for these purposes?
Bob, or, is it William suggesting that a 50's 4 plex, an 05 duplex and a 70's 8 plex are apples to apples? Surely not. I'd even take issue with two more similar properties, one professionally managed and the other managed by ma and pa. Maybe that's not the suggestion?!?!
Little confused....but anyway......
The IRR assumes also that income received earns the same rate as the asset, hardly ever could be the case unless it's a poor performing property. If your net income is $150 a month, what alternative investment is available for that amount to earn 7,8,9,10..12%? Let me know and I'll make you a richer man.
Well, no, it's not a ratio, it's a rate of interest, a yield required that is found by like but alternative investments.
"Similar" properties must be more similar than just rental properties, none of the 3 mentioned above are similar. Similar marketable locations, age, condition, management risks and ease of operation, rental demand and price.
Looking at these 3 properties, the cap rate would be found with other like properties, not compared between and/or each of those subject properties. From that, adjustments would be made as to the factors just mentioned to offset the differences of those properties, age, condition, etc.
The cap rate is best used when investment A, B, C and D are identical or very, very similar. Stocks or bonds of the same ratings and expected performance. Insurance annuities from similarly rated companies or REITs of the same portfolio quality.
The issue is, is that RE is not that similar. Cap rates are applied more by custom in RE than by the financial and economic accuracy of comparing alternative investments, it a method borrowed from investors in a totally different market, one that is liquid, carries very similar management requirements, degree of knowledge, ease of holding, income expectations and other functions.....in other words, the securities markets. RE is not the securities market.
Again, the MIRR is best suited as adjustments to any income stream can be made to compensate for the uniqueness, variations and similarities of alternative investments to identify a required yield. :)
I would argue that any number that can be expressed as a percentage is a ratio.
My point is that the application of cap rate is often misapplied in its conventional sense of determining market prices based market cap rates, but this number is not unimportant when looking at two dissimilar properties because it accounts for expenses where GRM doesn't.
If I'm looking at two very similar buildings on the same block, built the same year with the same square footage, but have different rents or prices, I don't have to do much number crunching to determine the better value. It's when these properties are not the same that we need some sort of baseline to compare performances.
Since you mention stocks, a very important valuation indicator is the price/earnings ratio which is essentially the same thing as the cap rate. If I am looking to buy Facebook or Alcoa stock these numbers are probably very different for a lot of reasons, but it isn't completely ignored by Wall Street just because that's not how it's supposed to be used.
I agree that real estate is a more complex asset than a security and am looking forward to learning about MIRR. But to restate @Marco Santarelli's argument, most clients shopping for smaller residential properties are only sophisticated enough to understand NOI (which we all agree is appropriate for any investment property) and price (also applicable). Why then is it that we are not to combine that relationship in a single number?
I think this is more about the semantic use of the term "capitalization rate" than what that number tells us.
I agree mostly, and yes a decimal can be shown as a fraction, in relation to the whole.
I understand that some of my posts need to be read several times to be digested and understood, I'm working on that. But I won't repeat it all again. But a cap rate won't tell you much, the more unlike the alternatives are the less useful it is.
Just looking up the MIRR won't dig deep enough to really grasp its applications. Underlying functions apply, marginal propensities of economics, finance and accounting apply:
Look up marginal propensity of;
Consumption, investment, productivity, labor, profit, probability, value theory and utility.
These understandings will make the MIRR dance for you in forecasting.
If you don't prof the discount rate or rate variables you can come out with garbage too.
But, rentals aren't that hard or small commercial. :)
I would argue that any number that can be expressed as a percentage is a ratio.
But to restate @Marco Santarelli's argument, most clients shopping for smaller residential properties are only sophisticated enough to understand NOI (which we all agree is appropriate for any investment property) and price (also applicable). Why then is it that we are not to combine that relationship in a single number?
Because we don't have price.
And if we make up a "price" such as asking, list, etc. That ratio changes UNTIL there is a meeting of the minds and someone actually makes a cap rate. Now if I know the market cap rates then I don't have to figger a hoped for cap rate every time the contract price is countered AND I have the knowledge that I KNOW WHAT MARKET VALUE IS.
Because I have the cap rate comps from CLOSED sales of similar properties. When you make up some minimum "expected" cap rate with no knowledge of the market cap rate you either will not close a sale or probably over pay.
Just looking up the MIRR won't dig deep enough to really grasp its applications. Underlying functions apply, marginal propensities of economics, finance and accounting apply:
If you don't prof the discount rate or rate variables you can come out with garbage too.
Thanks, I was ready to get a little more beaten up than that ;). As always, I greatly value your extensive knowledge.
One thing I like about the cap rate calculation is that it applies irrespective of the buyer/borrower so we don't have to add additional assumptions about financing and accounting, but can get a better idea of how the property has performed in a vacuum.
You also use the term "forecasting". This is very interesting and might get to the nut of this thread. I use this calculation (NOI/Price) to compare past or as-is performance (on potentially dissimilar properties in the same market), not to forecast.
Marco's title of this thread very much implies using cap rates as a target future return. I see now how that might lead to misunderstanding.
Finally, not familiar with "prof". Was that a typo?
Thanks again.
Because we don't have price.
And if we make up a "price" such as asking, list, etc. That ratio changes UNTIL there is a meeting of the minds and someone actually makes a cap rate. Now if I know the market cap rates then I don't have to figger a hoped for cap rate every time the contract price is countered AND I have the knowledge that I KNOW WHAT MARKET VALUE IS.
Isn't the price the variable? We all want to buy below market and this is a good way of assessing that. For example, my market hovers in the 5-5.5% range. But I am not buying those properties because I know I can do better. So couldn't you say that my minimum is above 5.5% in my market?
Marco operates nationally. If I am seeking 10% caps and am willing to deal with the risk that those kinds of rates imply (and ignore fundamentals of why caps differ from market to market), I need to look to elsewhere. It gets us back to all the turnkey threads on cash flow vs everything else.
Out of curiosity, what are caps in Honolulu?
One thing I like about the cap rate calculation is that it applies irrespective of the buyer/borrower so we don't have to add additional assumptions about financing and accounting, but can get a better idea of how the property has performed in a vacuum.
You also use the term "forecasting". This is very interesting and might get to the nut of this thread. I use this calculation (NOI/Price) to compare past or as-is performance (on potentially dissimilar properties in the same market), not to forecast.
Marco's title of this thread very much implies using cap rates as a target future return. I see now how that might lead to misunderstanding.
Spot on William! You got it.
@Account Closed
Isn't the price the variable? We all want to buy below market and this is a good way of assessing that. For example, my market hovers in the 5-5.5% range. But I am not buying those properties because I know I can do better. So couldn't you say that my minimum is above 5.5% in my market?
1. What do you mean by better? A higher cap rate is NOT better. Can you clarify?
2. Can you provide two actual cap rate comps in the 5-5.5% range that you are using to make your investment decisions?
3. If you are buying in a 5-5.5% market but not willing to buy unless the cap rate is higher then you are either creating a new market cap rate range, not closing any deals because why would someone sell to you under market price, or you are solving a problem with the property or the seller.
I don't really see the harm in vetting stabilized SFRs based on your own targeted cap rate. I'd take look at anything north of 6.00% in Dallas. On the other hand a 'Going In ' Direct Cap valuation on a non stabilized SFR is a little to academic for most people and not really practical.
I don't really see the harm in vetting stabilized SFRs based on your own targeted cap rate. I'd take look at anything north of 6.00% in Dallas. On the other hand a 'Going In ' Direct Cap valuation on a non stabilized SFR is a little to academic for most people and not really practical.
Why 6%?
One thing I like about the cap rate calculation is that it applies irrespective of the buyer/borrower so we don't have to add additional assumptions about financing and accounting, but can get a better idea of how the property has performed in a vacuum.
How does the cap rate give you "a better idea of how the property has performed in a vacuum"?
@Account Closed
Yes. I am buying investment properties below market by solving problems with the properties or for sellers. That is exactly what I do for a living..
Our small market is by no means efficient. On three deals this year, we sold at a premium to the only buyer who would want the property in question. Without that buyer it would not have sold at half the price. (We had some of those too). How do cap rates work in markets with limited activity and lots of insider dealings?
By "performing in a vacuum" I mean a number that would be the same for any borrower (financing assumptions) or any buyer (accounting assumptions).
Are your questions just rhetorical snipes or do plan on helping us learn something here?
Are your questions just rhetorical snipes or do plan on helping us learn something here?
Sorry that you consider any of my post as snipes. That is clearly not my intention. Can you point out a specific example?
I am asking questions so that I understand where you are coming from. I appreciate that you are answering. Others have not participated as well and I question their knowledge or reason. Where do you get cap rate comps to know you are buying under market?
@Account Closed
No worries, there was just a slew of one line questions and I wasn't sure if you were really looking for responses.
To answer your question, we have represented sellers on probably a dozen 4-plexes and a few light commercial buildings this year. We have tax returns and, on some, several years of property management numbers. Looking at the 4-plexes the prevailing cap is actually closer to 6.25%. These all are pretty similar properties in average neighborhoods. Under 6% they do nothing, over 6.5% we're in a multiple offer scenario from the get go.
The tolerance for poor returns on duplexes is quite high. We attribute this to some level of owner occupancy.
There's a lot of vacant commercial space here, but prices don't reflect it. We're caught between large portfolios that were built two generations ago and the alumni of a large development company headquartered here that enjoy having a building or two here while they make their money elsewhere.
It seems there is a lot of emotional cash parking here and/or very long term plays.
I'd love any insights on lazy inefficient markets.