These pages have seen more than a few posts directly or indirectly aimed at the subject of ‘cap rates’ — capitalization rates. What is a cap rate exactly? Excellent question. Here’s an excellent answer. In its simplest form, if an income property sports a Net Operating Income (NOI) of $8 and the price is $100 — the cap rate is 8%. In other words, if you paid cash, the 8% would be your cash on cash return. I’ve found that’s an easy way to think about it.
Here’s another way. High cap rates generally speaking sport higher cash flow. Also, the higher the cap rate the lower the price is in relationship to the NOI.
I was once asked what I’d do if I had a $50 Million dollar bill.
Having 50 million dollar bills would change everything. I’d be a total hypocrite and buy all the super located NNN leased properties with high cap rates I could get. I’d also acquire a few 5-star mobile home parks, and/or some well located mini-warehouse storage operations. Then I’d make sure all the checks were wired to the correct bank account — which would be my management time each month. 
Of course I wouldn’t really be a hypocrite, cuz that’s what I’d do for anyone with that kinda scratch. They’d want quality no-hassle cash flow. At that point the real estate investor has obviously reached their end game — stress free, tax sheltered and/or tax free retirement income.
A long time ago I was told it would make sense to buy high cap rate properties with the $50 Mil bill — in L.A. — East L.A. to be specific. Search my archives for ‘get outa Dodge’ and you’ll quickly see I wouldn’t buy anything anywhere near L.A. — regardless of the cap rate.
A block of duplexes in L.A. East or anywhere else, is what I’d avoid like the plague. Remember, I’m going for capital growth, not cash flow. East L.A. cap rates are of course higher compared to Beverly Hills cuz most folks live in the relatively low rental rate areas cuz they have to, and in areas with mansions cuz they wish to — and have the option on their menus to do so.
If duplexes are the target, 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 from Day 1. But let’s be perfectly clear — if capital growth is the goal, high cap rate properties have historically been a predictable FAIL. Either they don’t appreciate much, or their locations are so terrible…well, you get it, right?
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 California.
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 and cash flow is dealing with higher operating costs, and lower appreciation rates. Not to mention a brisk reality check!
I’ll even go a step further. Many have learned after the fact, and much to their chagrin, that the double digit cap rate to which they were so attracted, was in reality a mirage — if not flat out cooked books. Their actual NOI shows a cap rate far less than they thought they’d bought. Not a happy epiphany.
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. Is there anyone not in agreement with that? What if there’s no appreciation you ask? Think about it. If there’s no appreciation in the quality locations, what’d'ya think happened in the high cap rate crappola neighborhoods?
Ponder location for a minute. Do you live where you want to live, or where you have to live? If the deciding factor was subjective desire, 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. Roughly half of the 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 the 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 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. What Grandma taught us was right.
In fact, I’ll buy a bunch of California 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.
Do I agree that high cap rates are preferred to low? Of course. That said, only when they’re taken in the context of superior locations to begin with does it become a real life decision.
When caught in a candid moment, those worshiping at the altar of high cap rates will tell you — much of their real life experience has been major disappointment.
Let’s talk real estate investment as it relates to you. 619 889-7100 will get me. Have a good one.
Related posts:
- Cap Rates & 50 Million Dollar Bills — What WOULD I Do?
- Purposeful Planning & Cash Flow Management — Your Million Dollar Steak
- Picking Up Pennies — Needless Cash Flow — And Million Dollar Pizza & Beer
- Love High Cap Rates? Me Too — Ever Ask Yourself WHY They’re High?
- Real Estate Interest Rates To Rise…Oops!
About BawldGuy
When I see double digit cap rates my first reaction is “What’s the catch?”
I actually saw a laugh out loud counterexample last week near my weekend cabin. An old duplex (termites holding hands old) asking 19x rent. The kicker? They had been months trying to rent one half that was vacant.
The river Denial is a powerful body of water.