The problem with cap rates?

[Omi C.]

When I first learned about cap rates I thought that they were a great way to compare properties independent of any particular investors financing situation. It also sounded like every particular area/neighborhood would have a "standard" cap rate, which would also help in figuring out whether a particular deal was above, at, or below market rates.

However, now that I think I understand cap rates a bit better, they seem speculative, situation specific, and therefore unreliable as a tool for determining the merits of a deal.

I think this because the cap rate is so heavily reliant on the assumptions one makes about the costs of owning a property. My standard assumptions around costs include 8.33% vacancy, 10% property management, 10% maintenance, and 10% capex. However I am yet to see a single deal where anything close to these costs are planned for. The biggest cost seems to be some "actual expense" from the previous year which is generally around 5% of gross. Sometimes vacancy is included, but generally not - especially if the property is currently fully occupied. So with none of these costs accounted for, of course the cap rate is going to look great!?

Have I misunderstood something about cap rates? If you rely on cap rates when evaluating a deal, why do you do it?

[Bill Gulley]

Your guess at your expected cap rate will be based on the accuracy of your experience in the/that market, it's an estimate and not the basis for an investment decision. When cap rates are mentioned by sellers, or listing agents, you can pretty well ignore them, even if they are correct, without puffing and fluff, that is that owner's rate, your situation will never be the same.

50% is a drive by estimate, that can tell you if you should sharpen a pencil or keep on driving by. Not a basis for a good buy decision.

Learn to sharpen your pencil, know your market, accurate ARV and repair costs, time on market issues and lease up periods, your cost of money and best use of funds will tell you where you need to be. Good luck :)