How Chasing High Cap Rates Can Reduce Your Retirement Income

Two great phone calls yesterday. One about the ever present tug of war between capital growth and cash flow, the other about financing, and holding properties forever. Today I’m talkin’ about paying too much attention to obtaining high cash flow properties when the primary agenda is for capital growth. I’ll talk about the second conversation in a separate post.

What’s a cap rate?

Simple — Captialization rate is what you get when you divide the price paid for an investment (income) property into its Net Operating Income (NOI). If you paid cash it’d also be your before tax ‘cash on cash’ return rate. Example: Paid $100,000 with NOI of $8,000 = Cap Rate of 8%.

Having a 50 million dollar bill would change everything, wouldn’t it?. You’d probably buy all the super located NNN leased properties with high cap rates you could get. You’d also acquire a few 5-star mobile home parks, and/or some well located mini-warehouse storage operations. Then you’d make sure all the checks were wired to the correct bank account — which would be your management time each month.

Furthermore, you’d acquire an EIUL, using about 10% of your $50Mil. Note: I’ll be posting on EIUL’s soon, with cool examples. Bottom line on ‘em, is that they’re a superb source of tax free income which upon death offers a payoff to your heirs not subject to inheritance taxes. Like I said, cool.

At least you’d do all that if you followed my counseling. You’d want quality no-hassle cash flow.

Search my archives for ‘get outa dodge’ and you’ll quickly see I wouldn’t buy anything, anywhere in San Diego — regardless of the cap rate. I say this in the context of the typical investor, whether they’re lookin’ for capital growth or cash flow.

It’s About Context

A block of duplexes in East L.A. or similar type locations in San Diego (read: anywhere in California) is what I’d avoid like the plague. East L.A. cap rates are of course higher compared to Beverly Hills or La Jolla as most folks live in the relatively low rental rate areas cuz they have to, and in areas with mansions cuz they choose to.

I’d buy a bunch of 1-4 unit props in a growth region which allows for leverage, fixed rate debt service, quality tenants, and an acceptable minimum cash flow from Day 1. (Properties must ALWAYS pay for themselves from the start.)

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.

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 — 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 better rent/price ratios. In the end, most of the so called high cap rates turn out in hindsight to have been mythical when the Firestones hits the pavement 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?

You Want Tenants Who Choose To Be There

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? Betcha the rentals in those areas were relatively high.

In San Diego we have a perfectly good area in the East County, an incorporated city called El Cajon. Roughly 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 make a note of that gem.) 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.

In fact, I’ll buy a bunch of East L.A. or San Diego 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.

Of course high cap rates are 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.

OK, whose gonna call me today and gimme my fix? Let’s find out how you can massively improve your status quo. Here’s my number — 619 889-7100. Have a good one.

Related posts:

1. Love High Cap Rates? Me Too — Ever Ask Yourself WHY They’re High?
2. Cap Rates & 50 Million Dollar Bills — What WOULD I Do?
3. Chasing Discounts Is Often The Way To A Discounted Retirement Income
4. Real Estate Investors — Is Your Addiction To Cash Flow Lowering Potential Retirement Income?
5. Cap Rates & 50 Million Dollar Bills — What WOULD I Do?