Different uses for different people - Posted by Jim Beavens
Posted by Jim Beavens on May 13, 1999 at 15:07:53:
The point that Piper and JP are trying to get across is that the way an investor values a property and the way a homeowner value a property are very different things. You’re mistake is in assuming that all single-family houses are income-producing properties. Maybe it’s an income-producing property to YOU, but not to a potential homeowner. And the house is only worth what a typical buyer would be willing to pay. With a commericial property, that typical buyer is a fellow investor, who cares about nothing but $$$$. Thus the cap rate is a useful tool for unemotionally comparing the monetary return of this investment versus some other investment. But with a SFH, the typical buyer is a potential homeowner, and with them you have a pesky little thing called emotion enter the equation. Cap rates are useless here; people make buying decisions on things like whether there’s enough natural light, whether the garage has a workbench, and other things that have no bearing on what kind of rent the property could bring in.
If your acceptable cap rate says a house is worth $70,000, but all other similar houses in the area have sold for $50,000, then you’ll have that For Sale sign out in front of your house for a long time (and be waiting a long time for the bank to loan you money on this property).
I do agree that the cap rate is a useful tool for any income-property, but only when analyzing a property as a potential investment. The cap rate filters all the complexities of owning real estate down to a simple yield, which can be compared with the yield of other investments, whether it’s real estate, stocks, bonds, paper, etc. Although even here the use is questionable when dealing with 1-4 units because the lending criteria is so loose. There could be commercial buildings all over the place with 12 caps, but that little house with an 8 cap might be worth it because you might be able to swing a 100% NOO loan (this gets into the cash-on-cash aspect that Leapfrog brought up).
The only time you can go the other way, ie using the cap rate to calculate the value instead of the other way around, is with commercial real estate, where the ONLY consideration is income. And as I already pointed out, income is only one of many considerations when we’re talking about SFHs. Keep in mind the line starts to get blurred when you get into 2-4 units. Here you have a pretty good mix of owner-occupants and investors, so which valuation method to choose becomes somewhat more subjective.
One other mistake you made in your original post is coming up with a cap rate all by yourself. Nobody “decides” what cap rate they will buy at, the cap rate for the most part is dictated by the market. Piper probably salivated at your proposal to buy his properties at a 9 cap, since in many areas of Kansas City properties commonly go for cap rates of 12-15% (remember, Jim dubbed the midwest the “land of positive cash flow” ;).
The bottom line is that you can value a property any way you want, but whatever way you choose is irrelevant, since you personally have no bearing on what the property might be worth. The value is only determined by what the next guy might pay for it, so your valuation analysis should be done with that one underlying concept in mind.