Is cap rate everything?

Question

Hello BiggerPockets. I am in the process of buying my first rental property. I live in Maryland but I'm looking at properties in New York. I have a property management company for whatever property I choose to purchase but I just wanted to know you alls opinion on if cap rate is everything. The first property I'm looking at is listed at 159,000. I would have to get a mortgage on the property which would be about 700 a month. It has four units that rent for 700 each so I would gross 2,800 subtracted by my mortgage which would be 2,100 without expenses per month which was a 16% cap rate. The other property is listed for 45,000 and I would pay straight cash so I wouldn't get a mortgage. That property brought in about 1,100 a month with two units. That property had a cap rate of 23%. I just wanted to know your opinion on if you think that I should go with the property with the higher cap rate since that is what I was always taught, to not go with a property until it had a cap rate of 20+%. Look forward to hearing back from everyone.

Thanks in advance!!!!

Account Closed · Answer

Be sure you are calculating CAP rate correctly. It's NOI/Purchase price.  Your mortgage (debt service)  does not factor into the calculation. Good luck!

Mike R. · Answer

I think cap rates matter if it is an income property regardless if it commercial or residential (4 units or less).  Use it as a simple relative valuation tool But cap rates are not the only thing to consider.   Do more homework

Alex Franks · Answer

I don't think you should buy either until you have a better understanding of the numbers.

Promise I am not being an ass but in  my early years I purchased being to eager. Not really knowing the numbers . You are telling me you do not know the numbers just from reading a few of your post. Take some more time to learn the markets and numbers. Before you jump in.

Just my two cents but I think you will save some money ,and head aches in the long run.

Alex

Account Closed · Answer

@Joshua Womack for those prices in or near the NYC area, you're looking at terrible neighborhoods and tenants. Think section 8 and the straight up hood. Unless you mean, you are looking somewhere upstate NY, far away from the 5 boroughs.  I own a 2 family in Staten Island,  in a pretty bad neighborhood. For my first property and first time being a landlord, it was a tough learning experience dealing with that type of clientele. Be careful with what management company you hire, because just like you, they would not be so eager to go deal with these types of tenants. Good luck

Gino Barbaro · Answer

@Joshua Womack

Hi Joshua

what type of property is this: A B C D.

I own property in NY and with those figures I am assuming a C-.  High cap rates are great if you can collect the rent.  The only value a cap rate has is that you can compare it to other deals.  They are typically not used in smaller properties. There other value is to indicate where values are headed.

There is something called a risk premium, the spread between the cap rate and 10 yr treasury.  Let's say the cap rate is 8 and 10 yr t bond is 2, risk premium is 6.  When cap rates drop to 6, risk premium is only 4.  Do you want to only have a rate of return of 4, when you can put your money into t bonds for 2.  Obviously there are other factors when figuring out returns such as amortization pay down and tax advantages.

Savvy investors saw the writing on the wall back on 06 and 07.  Cap rates became infinitesimal in certain markets, just as they are now in certain markets (NYC for instance).  These investors sold and waited for the correction.  Wish I was one of them.

Gino

David Nolan · Answer

@Joshua WomackCAP rates are a function of the  assumed market value of a series of cash flows based on current economic  factors. A 10 Cap is a 10 year payback period where a property is paid for all cash and the NOI remains constant, a 5 CAP is a 20 year payback period under the same conditions, a 12 Cap has a 8.33 year payback period etc. It is simply telling an investor what the payback period will be given the inputs into the calculations used. The quality of the income stream is determined by the risk  associated with that income stream and thus the yield is a true  reflection of the market's appetite to risk. The higher the perceived  risk the higher the yield needs to be to attract an investor. The higher the yield the shorter the potential payback period will be. That is  why some properties have lower CAP rates than others. Investors perceive  lower risk in the lower yielding investments."

As @Gary VanBortelpointed out cap rate is a measure of NOI/Purchase price. If you change your purchase price you will change the CAP rate. Likewise, if the NOI changes so to will the CAP rate based on a fixed purchase price. So, when I want to make an investment decision I would look at the NOI and measure what I perceive as the risk to that income stream and then based on the yield I am happy to accept I would set my maximum purchase price to reflect that yield and thereby creating a CAP rate. Let me give you an example. Let's assume a NOI of $24,000.00 per year. Imagine the perceived risk warrants a return of 12% on my investment, assuming a full cash deal. So for $24,000.00 to represent 12% I would set the purchase price at $200,000.00. A yield of 12% on $200,000.00 is $24,000.00. This has payback period of 8.33 years assuming the NOI stays the same throughout. It would have a 12 CAP. A 12% yield on the purchase price based on current NOI.

However, the only true relevance CAP rates have is as a measure of perceived risk by the market overall in relation to the income stream from that property. It has nothing to do with what you can personally do to improve the income or reduce the risk. That is where the money lies. In being able to do either of those things or both. Increasing income and reducing risk will make the property more valuable as the quality of the income stream goes up the risk comes down so the expected yield is less, ergo the CAP rate will effectively be lower. Thus, if the income stream of $24,000.00 was made less risky and the market would therefore accept a yield of say 10% instead of 12% then the property would be worth $240,000.00 not $200,000.00.

Hope this helps.

Joshua Womack · Answer

Thank you @Lenzy Ruffin!!!!!

Lenzy Ruffin · Answer

https://www.biggerpockets.com/renewsblog/2010/06/30/introduction-to-real-estate-analysis-investing/

https://www.biggerpockets.com/renewsblog/2013/01/19/real-estate-math/

Stephen Franco · Answer

cash flow is king.

Cap rate is an indicator.

I do this;

Rent (say 600)

- 30% maint. Vacancy. Management

- costs landlord pays (taxes...sewer..etc)

-75 a month pocket cash flow

The rest goes to mortgage at 6.5% 20 yr .

Runs about 30k per finished tenant rented unit.

Luzerne county pa wins for that

Is cap rate everything?

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