When it comes to cap rates, my rule of thumb is that the higher the cap rate the greater the risk of investment. The lower the cap rate, the lower the risk. In more sought after areas, especially with commercial property, I see mostly lower cap rates. Some people see a cap rate of 6% and think that property is a horrible investment compared to a 9%. Can someone explain why this is? Thanks.
[QUOTE=aristotle;883987]When it comes to cap rates, my rule of thumb is that the higher the cap rate the greater the risk of investment. The lower the cap rate, the lower the risk. In more sought after areas, especially with commercial property, I see mostly lower cap rates. [/QUOTE]
Your assumption is faulty.
Cap rates are relative to the bond rates and the interest rates on other investments. If you can buy a risk free bond that is AAA rated and it pays 10% then the high risk investments such as real estate would need to pay more to compete for the investor’s cash. At the end of the day a commercial property is all about the income stream.
Cap rates are also relative to an area. Some cities or regions will have higher or lower cap rate because the demand for property is worse (high rate) or better (lower rate). The cap rate is what attracts the investors and when the demand from investors shifts the cap rate shifts.
Once all of the above has been factored in, then the cap rate will adjust for the risk of one property vs. another. That could be because of the location, the terms and condition of the lease or leases, the condition of the building and other things. If the specific property is less desirable than many of the others in the same area, the cap rate would need to be higher to attract an investor.
[QUOTE=aristotle;883987]Some people see a cap rate of 6% and think that property is a horrible investment compared to a 9%. Can someone explain why this is? Thanks.[/QUOTE]
When interest rates are low the cap rates will be low. There was a time here in London when cap rates for A class office buildings were under 4%. This is a signal that property prices were at or near a peak so it is more likely the prices will fall in the coming years. As it turns out that is exactly what they did.
A lower cap rate will also imply the building is not producing a great return before debt service. If the expense were to shift then there could be a problem with the cash flow. In some cases a low return over the next 2-3 years might be acceptable to a buyer the buyer. In this sort of situation the buyer is pricing in a lease change where the income will be significantly improved. The investor is willing to buy at a low cap rate because they want the property now and they know they will be able to improve the income later. A trophy property in a very prime location will attract buyers who will accept a lower cap rate.
My point is not to suggest an optimal strategy or number. You need to understand what influences a cap rate. The target is relative so the right number this month could easily be the wrong number in a year or more.
Thanks for the short response. Explain to me why some “investors” will purchase commercial properties with a 6% cap rate, compared to a 4-plex with a 15% cap?
[QUOTE=aristotle;883987]When it comes to cap rates, my rule of thumb is that the higher the cap rate the greater the risk of investment. The lower the cap rate, the lower the risk. In more sought after areas, especially with commercial property, I see mostly lower cap rates. Some people see a cap rate of 6% and think that property is a horrible investment compared to a 9%. Can someone explain why this is? Thanks.[/QUOTE]
You have observed somthing that is only true on the surface. Cap rates are net operating income divided by purchase price. Nothing more, and certainly not any kind of measurment of risk beyond the relationship between income and price.
Now, what you have noticed is that property with higher caps seem to be more risk, and somtimes it does seem that way, but its important to remember that high risk deals that are overpriced can have a very low cap rate. Not surprisingly, low risk deals that are underpriced can have a very high cap rate.
[QUOTE=aristotle;884003]Thanks for the short response. Explain to me why some “investors” will purchase commercial properties with a 6% cap rate, compared to a 4-plex with a 15% cap?[/QUOTE]
Only a beginner would base a purchasing decision upon cap rates alone, and thats the only good answer to this question.
[QUOTE=aristotle;884003]Thanks for the short response. Explain to me why some “investors” will purchase commercial properties with a 6% cap rate, compared to a 4-plex with a 15% cap?[/QUOTE]
Too many variables involved to base the decision on CAP’s solely. You also need to look at available financing as well. If you’re paying 6% for money you can’t be looking at a 4 CAP and expect to be making money.
Typically when I see a higher CAP on a listing its based on a proforma to start and when I see double digits I assume the deal is management intensive. With Multii-Fams Id see lower CAP rates on more stable middle of the road properties where I can get tenants that are responsible enough to MAIL me the rent monthly vs me having to drive over there on a weekly basis. Ive always heard there’s more money in lower income rentals but Id rather not deal with the additional issues for an extra 2 pts on the CAP.
Also keep in mind that most people dont even look at in the 1-4 unit category and most Realtors dont know how accurately calculate the CAP rate to begin with. So always do your own numbers.
[QUOTE=aristotle;884003]Thanks for the short response. Explain to me why some “investors” will purchase commercial properties with a 6% cap rate, compared to a 4-plex with a 15% cap?[/QUOTE]
Why do some buy apples even when oranges are cheaper?
Because they want one and not the other.
A 4-plex is a residential building, not a commercial building. Even if we were talking a 5-plex or bigger, some buyers want a hotel, an office mall, a strip center, etc.
As I said earlier, a higher cap does not prove the building is better. It might be a real junker or in a very bad location. You can inflate the cap rate just by lowering the price.
Side note. Using a cap rate to value 1-4 unit residential does not make sense. They are valued using the comparable method vs the income method (the one that uses cap rate).
[QUOTE=AmotoXracer;884005]… its important to remember that high risk deals that are overpriced can have a very low cap rate. Not surprisingly, low risk deals that are underpriced can have a very high cap rate.[/QUOTE]
A very good point.