We’ll begin by figuring just what a ‘cap rate’ really is. Start with the Net Operating Income (NOI) of an income property. That’s the money you have left over after all vacancies and operating expenses have been accounted for. You then take the price of the property and divide it into the NOI. (NOI/Price) The resulting number will be in the form of a percentage. An example might be .0712 — 7.12%. Price: $100,000 NOI: $7,120
Put in even simpler terms, 7.12% would be the before tax return if you were to pay cash for the $100,000 example property.
See? It’s not all that complicated. Here’s where the problem comes in though.
Real estate investors will obviously be attracted to the highest cap rates. Duh. Not only due to the superior return, but because of the inverse relationship between the cap rate and the price. The higher the cap rate, the lower the price. Seems pretty nice, doesn’t it? You find two properties to which you’re attracted — one sports a rate of 7.3%, the other 10.1%. But in reality, which is the better property when all factors are completely analyzed?
And there’s the rub. Hint: At this point ya may wanna invoke one of Grandma’s favorite sayings. “If it seems to good to be true…”
There’s an inherent conflict between relatively high cap rates and their respective locations. Think about it a second. Two duplexes pretty much equal in every way, except for price and cap rate. Where might you suspect each one is located? Wouldn’t you expect the lower priced duplex to be in a riskier and/or downright inferior neighborhood? Sure you would. That’s why it’s priced lower while generating the same income. Makes sense, right?
The ugly secret to the alluring high cap rate property, is that it’s almost always located in areas you simply shouldn’t be buying. The tenant quality will be lower. The expenses will be higher. If there’s any appreciation it will be less than superior neighborhoods nearby. It will be far more management intensive.
BawldGuy Policy: Wherever we take our clients, we invoke the same policy when location is involved. In a nutshell it says, “If I wouldn’t put my 78 year old mom in this property to live by herself, don’t bother calling me about it.” Funny, folks seem to understand exactly how we define an acceptable location. 
The final downside? In the end, many investors sadly learn the 10% cap rate they thought they’d acquired was, in reality roughly equivalent to the better located duplex they turned down in the first place. In other words, they just bought the real estate equivalent of lipstick on a pig. Paradoxically, it almost always pays to avoid high cap rate neighborhoods. Between increased expenses, higher vacancy rates, etc., etc., not to mention the pure aggravation, it’s just not worth it.
BawldGuy Takeaway: When looking at residential income properties, especially relatively smaller ones, cap rates can lead the inexperienced investor down the wrong road. Look at ALL the factors, and stop putting the emphasis on the wrong syllable.
Contact me to find out where you can acquire reasonably high cap rates in excellent neighborhoods. Call 619 889-7100 or use the Contact BawldGuy button up top. Have a good one.
Related posts:
About BawldGuy
Jeff –
The present state of the credit markets also make the cap rate a very weak metric to rely on.
The absence of conventional financing has put the emphasis on seller financing, and where conventional financing usually varied within a narrowly defined range, seller financing can be all over the board depending on the seller’s motivation and buyer’s negotiation skills.
So since financing is now a unknown variable, and since it’s not considered in the Cap Rate, the focus for me and my clients is good old pre-tax ROI.
The recipe for success in these real estate times in buy the best properties available in the best school districts that have the highest ROIs.
The ironic thing is that my spectacular properties that cost more (and rent for more) generally outperform rental properties in crappy areas because I keep them rented for 12 months out of 12, I rarely get calls from my tenants, and the properties aren’t trashed when they occassionally turn over.
Go figure.
Cap Rates = two legged stool. I prefer a full analysis taking into account financing, income, expenses and taxes. It’s more work. But hey, I’m funny that way.
To Dennis’ point I agree with school districts and rental properties. Problem is those properties generally cost so much more that they tend to be just outside many investors’ reach. But better to be patient to succeed than to hurry and fail.
Dennis — I thought this post might lure you out. Thanks for making my point with your real world example. Your buys are a once in a lifetime opportunity, considering the incredible quality of the neighborhoods in which they reside.
Your point about financing is killer too. The key to understanding the real world viability of any investment is the analysis of the entire picture, which is exactly what you do each time.
Thanks again.
Hey Chris — That’s what is so cool about Dennis and his current batch of acquisitions in MI. He’s buying in neighborhoods that have never in their history been able to support themselves as an investment with less than a burdensome down payment.
Your policy of complete analysis is why your clients smile when they see you.