Here We Go With Cap Rates Again – Real Estate Investors: Beware

Today’s post will be, at least for me, relatively brief. Just returned from speaking in Scottsdale, the freakin’ hottest place on earth, with Russell Shaw and Jay Thompson. Both of those guys are heavyweights in the biz. It was the best time on stage I’ve had in quite some time. But I be bushed and stuff.

Anywho, cap rates. (Capitalization Rate)

Plain English Definition: Arrived at by dividing the Net Operating Income (NOI) by the price paid, or contemplated. Example: NOI = $10,000 — Price = $125,000 — Cap Rate = $10,000/$125,000 = 8% Cap Rate.

Put another way — If the investor pays cash for this example, his cash on cash return, before tax, would be 8%.

This is all preamble to the false assumptions and/or pitfalls of chasing high cap rates. They don’t exist in a vacuum. A cap rate is merely another factor in a pretty full bag of factors — all of which have their own affect on your investment decision. Yet when I speak to investors countrywide, from time to time I get the feeling a property’s cap rate has been given far too much importance, relative to other elements in the decision making process.

Here’s the biggest snake in the woodpile.

Take a step back and try to find the common denominator running through most of the high cap rate properties you may have run across lately. If the numbers used to arrive at the rate in question are real (highly questionable 80% of the time, btw), you’ll notice the locations are, um, probably not of the highest quality. Let’s not be so ambiguous though, and define high quality location.

Over the years I’ve had to solve the communication problem arising when a member of my team in a region in which I’m doing business, tells me, “it’s a ‘great location’.” What the Aunt Fannie does that even mean? I solved it so that there’s virtually no misunderstanding about what the phrase ‘great location’ now means.

It means I’d put my 79 year old mom in it to live alone without battin’ an eye.

If someone figures a way to misunderstand that one, he’s no longer on my team. And yeah, it’s happened once.

Thing is, you’ll generally find that the higher the cap rate the worse the location. Think about it. The higher the cap rate is, the lower the price. If the location is so good, why is the price so relatively low as related to the income? Ya can’t have it both ways. Either it’s an excellent location or it ain’t. If it is, that cap rate just isn’t gonna be that high.

BawldGuy TakeAway: Cap rates aren’t the be all end all. They’re another tool of measurement. They’re also affected big time by their relative geographic location. Real estate investors who’re goin’ for cash flow should consciously resist being seduced by the many false assumptions underlying a high cap rate. Ask yourself: Would you put Mom in there to live alone?

Remember we want high quality tenants, stable rents, low and quick turnover. I’ll take a lower cap rate in that kinda neighborhood almost every time when compared to an inferior location offering a higher cap rate.

Those who chase high cap rates into the ambush of bad location and what naturally flows from those locations will suffer the consequences in increased expenses, more intense management, higher turnover, and slower rent up times.

Beware the high cap rate. It’s more likely than not they’re high due to either inferior location, or faulty numbers — or both.

Let’s talk about what you’re lookin’ to make happen. The first step is to gimme a call at 619 889-7100. Have a good one.

Related posts:

1. 7 Expectations of Real Estate Investors – Beware of Potential
2. The Real Facts About Capitalization Rates – Lipstick On a Pig
3. Real Estate Investors — Beware A Deadly Virus — Subjectivity
4. Tax Shelter — Real Estate Investors Should Beware the Professional Investor Trap
5. Cap Rates & 50 Million Dollar Bills — What WOULD I Do?