Worshiping At the Altar of Cap Rates? You Could Be the Next Sacrifice

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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. 🙂

About Author

Jeff Brown

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

16 Comments

  1. As a young investor (25) with one 4-unit, little cash, and looking to quit my engineering day job ASAP cash flow is a must for me. Therefore, the high-cap properties (like the one I own) are the most appealing and as far as I am concerned necessary to maintain my lifestyle. I’m looking to acquire a couple more properties and will have to assume a high % of debt to do so, the high cap properties are the only ones that work [i]for me[/i].

  2. Jeff Brown

    Greg — I get where you’re coming from — in fact I empathize big time. You can make your high cap properties work as long as you’re willing to sit on them like a mother hen. Over the long haul though, you’ll learn how much location, tenant quality, and ever increasing operating expenses will affect your bottom line.

    If you made a particularly good buy in a normally lower cap rate neighborhood, you’re way ahead of the game. If not however, the physics of economics, even grinding slowly as they sometimes do, will eventually drive you to seek less management intensive, higher quality tenants, and more predictable, higher demand areas.

    Have a good one.

  3. Seems to me that cap rate is a useful measure if considered in context — i.e., in the context of the market you’re looking at — and with other metrics that are equally important. It’s not so much that one shouldn’t “worship” the cap rate, it’s that it should be considered alongside other, equally useful analytical measures.

    [BTW, on an unrelated note, you might want to edit “poopooing” to “pooh-poohing,” which means dismissing/discreditng, versus “poopoo” which is something else entirely and not actually a verb! :)]

  4. Laurie — ‘In context’ is obviously the key phrase. We’re on the same page. Comparing apples to apples via cap rates generally, as you said, is another worthy tool. It’s when investors compare Beverly Hills cap rates to units located in economically depressed areas that they get tripped up. If I’m choosing between half a dozen properties in a tight and more or less homogenous area, cap rate will at least be somewhat of an indicator. As I’m sure you already know, the reconstruction of income & expenses are mandatory when doing that sort of comparative analysis so that the various NOIs have more credibility.

    Thanks for the catch on the spelling. You already made one of my client’s day. 🙂

  5. I definitely think we are on the same page. And I’m glad I could provide at least one person a laugh!

    Thanks for the article – looking forward to reading more of what you have to say.

    Laurie

  6. Great article! I’ve been a landlord for over 10 years, but just recently heard of this thing called Cap Rate. I’m not comfortable with any single “one-stop-shop” metric for evaluating anything, whether it be Cap Rate for an investment property, P/E Ratio for a stock, or height/age/weight for a mate! 😉

  7. Jeff – good article. I think it’s important that cap rates are compared to each other when analyzing similar properties.

    Personally, I’ve been shooting for a mix of high-cap but lower-income and lower-quality areas and lower-cap properties in more desirable location. And, admittedly, some of these high-cap properties are hard to resist – 20-25% unlevered returns leave a lot of room for mistakes and put a nice chunk of cash in your pocket. In an environment where we may not see appreciation for a a very long time, cashflow is just about all i am prepared to bank on.

  8. I’ve been a full-time investor for over 8 years now, supporting my family with the positive cash flow from my rental properties. Some of them were foreclosures and short sale properties lost by “investors” who were really speculators.

    I agree with most of your advice about bad areas, bad tenants, etc. (I wouldn’t buy in East LA either.) However, if someone borrows tons of money to buy rental property that just barely “breaks even,” they face two huge risks: 1. Unexpected problems (like falling rents, too many repairs and/or vacancies) can literally force them into foreclosure if they do not have deep pockets. 2. There is no guarantee that the property will appreciate fast enough to bail them out of an “investment” that has no regular monthy profits (example: California real estate, down 30-50% since 2006). So cap rates are very important because if they’re too low, your “investment” will turn into a life-sucking money pit. But the cap rates need to be real, not estimated or “pro forma” (that means “made up”).

  9. (continued from above)
    If something that you buy has a regular monthly return/profit, it can rightfully be called an “investment.” If whatever you buy has no regular monthly return/profit, and it has to be sold to realize a profit, then that is speculation, not investing (like buying stocks that do not pay dividends). To avoid this, the REAL cap rate (not the BS “pro forma” one provided by sellers and their Realtors) is crucial. The real cap rate tells you how much real money you should have every month to cover the mortgage payments and provide the profits that make it a real investment. And you get the real cap rate by looking at the seller’s real Schedule E for that property, provided directly to you (in writing) by their CPA.

    Cash is king. If you’re not getting spendable cash every month from your rentals, you’re not “investing” and you’re not “wealthy” — no matter how much you think you’re worth “on paper.” Many paper millionaires in real estate have ended up in foreclosure and bankruptcy because they lacked the positive cash flow to hold on to their property during rough times. (This is now happening all over the country.) Don’t make this mistake!

  10. Hey Mark — We’re pretty much on the same page — you’re preachin’ to the choir. 🙂

    When the request for the ol’ Schedule E comes out, folks begin makin’ excuses, don’t they? That’s when the cap rate, as you so correctly commented, falls.

    Again, cap rate is good, but under these conditions.

    1. The ‘analyst’ actually knows what a cap rate is.

    2. The income, vacancy, and expenses are real, as is the income. Duh

    3. The properties being compared are in roughly the same area — apples & apples and all that.

    With hen’s teeth exceptions, our clients generally generate 5-8% cash on cash even when they’re basis for investing is for growth. Thanks again.

  11. Pingback: Personal Financial Planning this Week | Personal Investment Management and Financial Planning Blog Directory

  12. Jeff,
    Your article just helped me make my decision on a 26 unit property I was considering
    I own 3 buildings in a good part of town that I maybe paid a little more for, but have good quality tenants and lower operating costs. This particular property comes witha high cap rate and huge roi but with a cost to that as tenants are of the lowest quality, property needs capital improvements and is located on the wrong side of the tracks, which I am not used to. Your article basically reaffirmed my suspicion as I will go with my better judgement and wait for a more quality deal. Thanks again!

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