Battle of the Cap Rates

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Want higher ones, right? I don’t.

Confused? I don’t blame you. You heard me right. I am just recently more impressed with 7-10% cap rates than 12%+ cap rates. I’ve had just enough experience in the rental property world to teach me that there is some real value in not ruling out those lower cap rates!

What is a Cap Rate?

A cap rate is a measure of the purchase price of an investment property compared to the net income you make from that property. If you pay all cash for a property, it’s the measure of how much you make on the property compared to how much money you put in, which is the same as your cash-on-cash return. If you finance a property, your cap rate is different than your cash-on-cash return. Cap rates are the general calculation done on most investment properties to give the buyer an idea of how good the investment may be, so for now, I’m sticking with those.

The Cap Rate equation:

Annual NET Income / Purchase Price = Cap Rate

Today’s Rental Market

It’s hard to say what a good cap rate is. In general, I would say anything over a 6% cap rate is potentially a good investment (I say potentially because there are of course other factors involved). This goes for residential or commercial, big or small.

For single-family homes and duplexes today, with the market where it is, my observation is that rental properties are ranging from 6% caps to upwards of 20%. Of that range, I would say 6-15% is with more expensive homes or turnkey rentals. Higher than 15% and you are most likely dealing with fixer-uppers. For the purposes of this article, I’m going to stay focused on the turnkey rentals since those are what I deal with personally, plus it keeps things more simple because going into how rehabbing affects returns is more complicated than the point I am trying to make. So I’m going to address the 6% to 15% Cap Rate range.

Higher or Lower Cap Rate?

Various factors go into what makes a good investment property. What condition the house is in, what area it is in, the kind of tenants most likely to move into it, your exit strategy, and the list goes on.  As I continue to work around rental properties, I’m noticing more and more the patterns between purchase price, cap rates, and quality. The cap rates in various markets are starting to merge due to the upswing of the general real estate economy (in my opinion), but there are still fairly clear distinctions between what markets can give you what cap rates. If someone tells me they want the highest cap rate possible, I steer them to one market. If they are more concerned with quality and appreciation potential, I steer them to another market. Every once in a while there is a market that has a great combo of all things awesome- high cap rates, high quality, and high appreciation potential. For example, Phoenix about three years ago and Atlanta about a year ago. There is a reason why the institutional funds and investors flooded those markets! Outside of those rockstar markets though, there is a lot more distinction between your options.

With some exceptions, here are my general observations between the higher and lower cap rates in turnkey world, so the difference between 6% and 15% (and these are very generic assumptions and vary between the markets):

• High Cap Rates (15%). Purchase price ranges $30k-50k. Fully rehabbed, but older properties probably early 1990s or older, if not 1970s and older. Not in bad areas necessarily, but definitely not fabulous. Areas with more renters than owner-occupants. Appreciation potential is only mediocre to minimal over any general economy appreciation.
• Middle of the Road Cap Rates (8-11%). Purchase price ranges $60k-100k. Houses are probably late 1980s-mid 2000s in age. Not horribly small houses, nothing gigantic. Still probably in more renter-heavy neighborhoods but more solid on tenant quality. Appreciation potential is probably in line with the general economic upswing.
• Low Cap Rates (6-7%). Purchase price ranges $100k+. Much newer houses. In markets that are much more heavily owner-occupied than renter-heavy, more “popular” or “sexy” markets, and possibly markets that aren’t really considered to be as investor-advantaged because of the price-to-rent ratios, but people still want to own there.

I feel compelled to emphasize again, these are extreme generalizations and there are exceptions to all of these.

Which Cap Rate to Choose

At the end of the day, deciding what investment property to go with ultimately depends on your preferences. What do you want to accomplish, and what are you most comfortable with?  A lot of people aren’t comfortable investing in areas that produce the higher cap rates and consequently they will invest in a market solely because it is that market and returns are second to that. One example is Phoenix. Right now, turnkey rentals are giving about a 0-3% cap rate there. Believe it or not, they are still selling! The people buying there now are set on owning in Phoenix and the minimal returns don’t matter. On the flip side, some investors only care about cap rates. Opposite of Phoenix, Detroit can give extremely high cap rates and if cap rates are all someone cares about, there you go! Never mind the market quality or who would ever want to live there.

I used to shoot for the highest cap rates I could find the in the areas I liked best. I never sacrificed total quality to get that high of a cap rate, but I was definitely more inclined to stay on the higher side. Since then, however, I have learned a lot about the returns shown on paper and the real-life returns. More specifically, long-term returns.

Right now, if I were to decide to buy another property, market of my choice, property type and style of my choice, I would choose the $80k-180k price range with 6-10% cap rates. All day long, no question. Here’s why:

• Tenant Quality. Tenant quality is what matters for an investment. If you have bad tenants, you will lose your hind side. No question about it. Evictions cost money. Vacancies cost more money. Repairs are never-ending. While this won’t be the case for every sub-$30k property, which is where you are going to see those really high published cap rates, who exactly do you think is moving into a house worth less than $30k? It’s most likely not the most upstanding citizen! Anyone with any sense of responsibility and care is most likely in a position to rent a nicer place in a nicer area. Maybe not even that nice, but not sub-$30k.
• Property Condition. Houses deteriorate, and when they do, they get expensive! All houses will need work, there’s no way around it, but the difference between a sub-$30k house and a $100k house is likely to be in the tens of thousands of dollars, if not more. Money aside, hello stress. I don’t want to worry about maintenance. Every time I hear something broke in one of my properties, I cringe. I prefer to have as few of those calls as possible.
• Appreciation Potential. I will never buy a property solely banking on appreciation, but let’s be honest, if I can get some appreciation, I’ll take it! Sub-$30k properties are doubtfully going to appreciate by much (not including flipping properties). Owner-occupied style houses in nice areas, however, by far have the best potential for increasing value. The advantage to the appreciation is my ability to use that new equity to roll into other investments!

All of this comes down to the long-term returns of a property. If you have an old house with not the best tenants, you are going to pay a fortune in vacancies and repairs. With that said, if you account for these when you are analyzing the property, then there’s no harm done.

How to Calculate an Accurate Cap Rate

Most investors are good at calculating all of the known expenses for a property- insurance, property taxes, property management (if applicable), and HOA (if applicable). What a lot of investors don’t do, however, is calculate in vacancies and repairs. Obviously there is no way to know this number for sure, but you can certainly make an educated guess.

For my turnkey rentals, I usually estimate 7% of the monthly rent for vacancies and 5% for repairs. The vacancy allocation is really just an average and I could tweak that more accurately if I look up vacancy rates in the area I’m buying in and talk to the property managers and see what the going rate is. The repairs on the turnkeys are typically very minimal to start because they are newly rehabbed properties so likely don’t have a lot of work needing to be done right away. Remember too though, just because a property doesn’t need a lot of work in the first year or two, repairs will start coming, so be conservative with your estimates initially to account for the back-end.

As soon as you get into cheaper properties, i.e. higher cap rates, you are very likely going to see higher vacancies because of tenant quality and more repairs because the properties are older. I wouldn’t put it past a property to need to be estimated at 20% vacancy and 25% repairs. You think I’m exaggerating, I’m absolutely not. That could even be on the low-end for some properties. If this is the property type you are dealing with, fine so be it, but make sure to estimate the realistic vacancy and repairs from the start. If the guy with the megaphone is shouting “20% cap rates, come and get ‘em!!” and the property was built in 1972 and in a fairly low-income area, I’d almost bet he has left out vacancy and repairs estimates, but even if he has included them but only used the 7% and 5% estimates rather than the 20% and 25% estimates, he’s totally off with his 20% claim.

Vacancies and repairs will tank your investment!

Be sure to account for them appropriately. And seriously, don’t kid yourself and swear they won’t be that bad. I have nice properties in nicer neighborhoods and I’ve lost out numerous times due to both of those! In those cases, it was more property management related, but the fact remains, bad tenants and property quality and your investment tanks.

For me, as a more seasoned investor now, I am so much more willing to look at 7% cap rate properties than I ever was before because the returns over the long-run and the decrease in stress make my investment so much more worth it, both in monetary returns and sanity.  I don’t expect everyone to agree with me, and a lot of investors enjoy the challenge of doing a lot of the work themselves and managing tenants, but for the hands-off investor like myself, nice houses and good tenants are the way to go. As always, there will always be exceptions to every rule and not every expensive property with a low cap rate will be flawless, but the risk is significantly less than with the cheaper “higher cap rate” (I use that term loosely) properties, and even if a tenant flops, you have a better chance of fixing the problem with the next tenant. Think about it- one bad roof on a property and what does that do to your returns that year? Especially if your tenants are only paying $500/month!

In case you haven’t completely followed what I’m trying to say, the moral of the story is- I would buy a $120k property with a 6% cap rate any day over a $40k property with an 18% cap rate. I guarantee it is a rare occasion that the $40k property will actually see that 18%. Even if it does, there will probably be so much stress with it that again, I have no desire.

What is your experience? Anyone invested on both sides of the cap rate spectrum?

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.