Why is CAP rate not best for analyzing residential properites?

Question

Question....  I have read CAP rates are not best for analyzing residential properties, and are better for commerical. Is that correct, and if so, why?

I am looking into multi-family properties

Daniel Akerman · Answer

Nick, first of all it would be helpful to clarify some terms. Residential, commercial, and multi-family are all terms that allow for some confusion. A multi-family of 5 units or more is considered commercial property by lenders, for example. You won't get a residential loan on them. A multi-family of 2-4 units is considered residential property by lenders.

One of the reasons cap rate is used for commercial properties, including multifamily properties for 5 units or more, is because of the appraisal techniques used in valuation of the properties. It is assumed that commercial properties and multifamily properties of more than 4 units are purchased for their income, therefore the income approach to valuation and appraisal makes the most sense. On the other hand, it is assumed that SFHs and small multifamily buildings of 4 units or less will be used by the end user (i.e. consumer), and in that situation it makes more sense to do the valuation based on comparable sales. Using these techniques allows the lenders to more accurately collateralize their loans and therefore protect their risk.

One of the more useful metrics for 2-4 family buildings is GRM, rather than cap rate. Since cap rate is really only appropriate for larger residential income properties, GRM becomes a good substitute. But comparable sales will also factor in somewhat because, at the very least, the seller will be looking at comparable sales to arrive at a list price. Understanding both will give you more angles from which to approach negotiations with the seller.

Cap rate is better for commercial (including multifamily of 5 units or more) because it focuses more exclusively on the income potential of the building vis a vis other buildings in the same area and of the same type, which is, after all, what you are interested in.

All that said, I've seen very few people who calculate cap rates correctly. Listing agents almost NEVER calculate it correctly or honestly. Make sure you see a full income/expense breakdown and calculate the NOI yourself, and include any additional expenses you would have.

Russell Brazil · Answer

Cap rate is really just a way to make an apples to apples comparisons between Asset A and Asset B.  Since commercial properties often (though not always) trade based on cap rates, then they can be a useful measure of comparing two properties.  Residential properties typically do not trade based on a cap rate, but rather based on the sales numbers of comparable properties.

Trevor Lybbert · Answer

Cap rates are generally used when using the Income Capitalization approach to valuing property. Generally, you're using the income method on commercial properties, such as 5+ unit apartment buildings. Residential properties with between 1 to 4 units, are valued using comparable sales.

If you get a 5 unit apartment building, then if you increase the net operating income, you increase the value of the property. If you have a 4-plex, it won't be valued off of the income, but only for what comparable properties in the area sold for, no matter how much more income you might be able to get it to produce.

Some of the reasoning behind it is that commercial properties vary widely, and are mostly investors purchasing commercial properties anyway, and it is easier to compare different properties when just looking at the income.

Daniel Akerman · Answer

Many may disagree with me, and I'd be interested in hearing their opinions and reasons as to why, but I think cash on cash is a poor metric to use. It's certainly my least favorite measure of an income property. I feel it captures a very narrow slice of the total investment picture and that there are far better indicators of whether a property is a good investment or not. I could care less about cash-on-cash. What matters to me is overall cumulative ROI. GRM is great because it shows you the income potential of the property in relation to the property value itself (irrespective of how you structured the purchase), therefore giving you a sense of the intrinsic value of an asset, irrespective of how much cash you bring to the closing table, which cash on cash does not.

Larry Turowski · Answer

@Nick McBride Any investor wants to know, how much money am I going to make?  Since cap rates determine both the return on investment as a rental AND the value of commercial properties (as the value is based on the cap rate), they are a very useful tool when analyzing commercial properties.

With residential properties (1-4 families) cap rates will tell you what your return on investment as a rental, but will NOT tell you the value of the property.  You really need both pieces of information.  You might buy a residential property with what you think is a great cap rate of, say, 15% and find that you could never sell it for anywhere near what you paid for it.

Rick Pozos · Answer

The reason cap rates work for larger properties is because income is very steady. If you have a 100 unit apartment, chances are that a few people will come and a few will go. Changes in income may vary 2% maybe 5% on any given month. Very little change.

When you have a duplex and both people move out, you have ZERO income. If that happens for 1 month, which is very normal to happen, there is already 8% vacancy. If you have someone move out on time and it takes total time of 1 month to get someone back in (again, very normal) you lose another 4% vacancy for the year. It takes time to paint, fix items, market and get someone in the unit.

That is not steady income that can be projected for the next year with any certainty. There is no certainty to your cash on cash return because it is too easy to lose 50% of your income for the month.

The cap rate or cash on cash is only if everything goes right. 5% or 8% vacancy can be correctly estimated for a large complex. For a duplex or 4plex MAY happen, but there is a bigger chance that it will be closer to 15%.

IF you have a couple of good tenants that pay on time and stay for a few years, you will have better than expected numbers. Tenants tend to be mobile though. For the larger complex you can mitigate your tenants by the volume and how little effect that a few people will have every month.

Mike Dymski · Answer

Profit in real estate comes from cash flow, principal reduction, and appreciation (forced or market).  IRR captures total profit and helps to properly compare investment alternatives.  Other metrics such as CoC, GRM, and the un-levered ROI (called cap rate in this post) have utility as well.

Nick McBride · Answer

Thanks everyone for their input! To add to the comments with another question.... I have read that GRM and cash-on-cash return are good metrics to analyze residential properties. What is the difference between GRM and CoC return, and where would you use one metric vs the other?

Jay Hinrichs · Answer

although I think this phenomena of every day investor buying SFRs as rentals and then neighborhoods turning to rental dominated IE majority rentals.. cap rates/ or COC return with 20% down tend to drive what folks will pay.. but everyone has different expense projections … but in these areas there simply is no homeowners buying them so comps tend to be all the sales between investors .

where as if I sell a 450k new construction and some just happens to rent it.. but 20 others are all owner occ.. no one is going value that home based on income .. or GRM  .. not sure if I am making sense.. I have Salmon going on the green egg on a cedar plank with a maple rub got to run !!!

Why is CAP rate not best for analyzing residential properites?

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