Read almost any real estate investment book and there’ll be a chapter or two paying homage to the almighty capitalization rate — cap rate. First, let’s ensure we’re all on the same page here. What is a cap rate anyway?
Fairly simple and straightforward — it’s the percentage resulting from your Net Operating Income (NOI) divided by your total cost of acquisition.
For example: If NOI = $10 and you paid $100 including all closing costs, your cap rate would be 10%. 10/100 = 10%.
Put another way, it would be the cash on cash return if you’d paid cash for the property. Most of the time it’s a relatively misleading, sometimes dangerous way to make your final decision to buy or pass. Using cap rates to buy properties is like playing hopscotch in a minefield — not recommended. This would be mostly for small to mid-size properties.
Here’s why — false assumptions abound.
Not long ago I had an investor from another state take me to task for poopooing cap rates as decision-makers for small to medium investment properties — sometimes even large ones. His point was that the cash flow is better, so why not build in your analytical bias for higher cap rates? If that was all there was to it, his point would be well made. The problem though, is the insistence of the real world on sticking in its ugly head.
He compared buying high cap rate properties in places like East L.A. to those in high demand/lower cap rate areas.
I’ve written gobs of ‘get outa dodge’ posts and you’ll quickly see I wouldn’t buy anything anywhere near L.A. — regardless of the cap rate.
A block of duplexes in East L.A. is what I’d avoid like the plague. Remember, in this discussion I’m going for capital growth, not cash flow, though frankly my argument works for cash flow as well in most cases. In times like the present, going for cash flow in high cap areas can have a very nasty boomerang affect. East L.A. cap rates are of course higher compared to Beverly Hills as most folks live in the relatively low rental rate areas cuz they have to, and in areas with mansions cuz they have the choice financially.
I’d buy a block of duplexes in a growth region which allows for leverage, fixed rate debt service, quality tenants, and a break even or better (preferably better of course) from Day 1.
We don’t ‘expect’ higher appreciation, we research, apply our expertise, and make a prudent judgment call. Let’s take a growth area in Texas and compare it to your block of stuff in East L.A. Don’t like my L.A. example? Use your own, local low-income area.
- Texas property will most likely be new or newer
- East L.A. um, will not
- Many Texas duplexes, town homes, etc. will break even or better at 20% down
- East L.A. will too — maybe even better.
- Managing Texas properties can be done by my 79 year old mom
- I can’t see either me or you allowing our mothers to manage in East L.A.
- For every East L.A. investor I’ll have 10 Texas buyers when it’s time to sell
- Many Texas duplexes sport separate tax ID’s for each side which = premium at sale
- 5 years from now Texas props are just 5 years old — East L.A.? Who cares? They were old when you bought ’em
Again the point: In residential income property, cap rates, at least for the relatively smaller units (1-4) are not all that crucial. The rent/price ratio is probably far more critical. And yeah, I realize that contributes to the cap rate, so don’t have a coronary. Still, the lower the tenant quality, the higher the management costs. Much of what you think you’re gaining in cash flow you’re giving back in increased operating costs. Those insisting on diving into high cap rates and cash flow when their agenda is primarily capital growth, soon realize how cold the water real is. I’ve been there, and it’s no fun. Turns out one of the unintended consequences of chasing high cap rates is dealing with higher operating costs, lower appreciation rates, and huge management time whether you do it yourself or simply monitor a pro. Oh, and a brisk reality check! 🙂
Isn’t that backwards? Yep — so stop it. It makes no sense in real life to buy properties in obviously inferior locations so you can point to high cap rates and marginally increased rent/price ratios. In the end, most of the so called high cap rates turn out in hindsight to have been mythical when the rubber hit the road anyway.
Remember — the idea is to grow your capital. A few thousand bucks over a 5 year hold period is just not worth receiving $50,000 less in appreciation — or having an ancient property on your hands — or having virtually no buyer demand when you need it most. Is there anyone not in agreement with that?
Think about location for a minute. Do you live where you want to live, or where you have to live? If the deciding factor was financial, and you’re living where you want to live, where did you avoid?
In San Diego we have a perfectly good area in the East County, an incorporated city called El Cajon. Half of their population rent. The rent is far lower for comparable property than the contiguous city of La Mesa. La Mesa is a popular place to live, and has been for as long as I’ve lived in San Diego — 1967. El Cajon on the other hand, at least for renters, is the option of choice only because their rents are far lower than can be found in La Mesa.
Guess which city has higher quality tenants, lower cap rates, better appreciation, and higher tenant and investor demand? Duh. We’ll consider that question rhetorical. 🙂
The lesson here is simple: What’s in text books and what you find in real life aren’t the same. (Stop, I wanna write that gem down.) 🙂 High cap rates in a book are cool. Yes, I’d rather have the property in chapter 5 of How To Be a Successful Real Estate Investor, no doubt.
Here’s the dirty little secret.
They virtually don’t exist and haven’t since I was born. They simply aren’t worth the trouble. And in the end, the appreciation is terrible when compared to the so called inferior cap rates elsewhere. They’re selling at higher cap rates (lower prices) for a reason. Ask yourself why until it hits ya.
In fact, I’ll buy a bunch of East L.A. duplexes and trade them for a small loss for some of your brand new Texas duplexes — and I’ll give you a small profit to boot. And in five years I’ll be so far ahead in any way you wanna measure I won’t be able to see you in my rearview mirror.
I wholeheartedly agree with the investor who took me to task that high cap rates on preferred to low. That said, only when they’re taken in the context of superior locations to begin with does it become a real life decision.
This must be one of those areas in which he and I differ by ‘degree’. We’ve always gone our separate ways on this issue. Still, I’ll bet given the choice, he buys Texas duplexes before he buys East L.A. In fact, I know he already did. 🙂