Determining your Cap Rate

[Valerie K.]

Hello BP! Can any experienced investor share their process for determining their personal target Cap Rates? I see a lot of blogs and listen to podcasts where seasoned investors have a distinct target for this number.  All I know is the basics- higher rate, higher risk/higher return.  I have never seen anyone put boundaries around cap rates that define them for specific asset classes or otherwise distinguish what they are looking for.  For example, if I tell you I look for Cap rates of 10 or less, what information does that convey to you?

Any insight greatly appreciated!

[Stephen Stokes]

@Valerie K. I think about a cap rate this way; if you were to put your money into a risk asset like real estate, what is your expected cash flow return requirement? It is all individual preference what you want to set YOUR threshold at. So at the end of the day you need to make a personal judgement call on what you are willing to exchange for in order to part with your capital and put it at risk. Those with a lot of capital or those investing with other peoples capital are able to accept and feel comforted much lower returns. Those with smaller amounts of their own capital who have to work extremely hard just to build that capital should be demanding higher returns. Again, you are parting ways with YOUR capital, and the exchange you make needs to be commensurate of the risk/return profile you are comfortable with.

I personally shoot for 5% cash flow returns on my investments. Any appreciation or other benefits are just cream on the cake for me. My rationale is that I can achieve around 4% through macro market ETF’s in the stock market which require no hands on work so 1% additional cash flow is commensurate for the amount of work I put into my buy and hold real estate investments. Again, that is just my preference and each individual is different.

Now, being able to achieve your threshold is dependent on the macro market cycle position, current interest rates, the micro market, the target asset quality, the neighborhood quality, and how you source your deals.

If you seek to buy in Austin, want to have a 10+ cap rate, sourcing deals that are listed publicly, you better be willing to buy properties with lots of deferred maintenance, high vacancy rates and in “war zones”. This may still be a difficult feat to achieve as the risk premium that is added to the risk free rate (treasuries) needs to be significantly large since the risk free rate is basically zero. This risk premium also varies with market cycles as demand for risk goes way down when there is blood in the streets and way up when the fed is printing money like crazy.