Is 2.5% a good cap rate? "Gambling" on appreciation?

Question

I recently saw a deal on a duplex in San Francisco in a prime neighborhood with a cap rate on existing rents of 2.5%. Rents a bit below market, but not crazy. Building in good condition. Great location. This number will look insane to 90% of people on BP. Obviously, part of the expected returns on a property like this are the appreciation returns. Historically, these have been phenomenal in SF. Prices barely dropped during the crisis and are already well above that for most locations. Limited space in a dense, unique metropolitan area. But you'll likely be coming out of pocket every month unless you buy cash or put down a crazy big downpayment.

So is buying a property at a 2.5% cap rate in a prime neighborhood in a prime city like SF really more risky than buying a property with large amounts of cash flow today in a B or C area? If you look at the price volatility over time, especially through the crisis, the SF property makes it look like much less price risk and income fluctuations. On the other hand, you don't get any returns unless it keeps going up.. I own in the East Bay, but not in San Francisco now.. Thoughts?

Michael Seeker · Answer

I would be okay investing for appreciation on a small portion of my portfolio as long as there is very strong demand and the rents cover everything in any normal month.

It is certainly more exciting to invest in areas where you can find tremendous value growth than those where you're limited just to the net monthly income.

That being said, I definitely wouldn't risk more money in that area than I was prepared to lose.  Just because prices didn't drop much during the bubble doesn't mean they will go up forever.  I'd also still be looking for an appealing property that would make a great long term hold and cash flow well 2-3 years down the road with increased rents.

Are you having trouble finding good cashflowing properties or do you just anticipate the value in the SF area to continue its upward trajectory?

Mary B. · Answer

J. Martin This link is a must read in your case....

http://www.biggerpockets.com/renewsblog/2013/03/30/battle-of-the-cap-rates/

Kudos,

Mary

Jeff J. · Answer

It depends on your risk tolerance, and understanding of the market.  A business strategy that relies on appreciation is pure speculation.  I have a portion of my stock portfolio where I bet on dips or try to anticipate a market.  I was up 100% over two years, then I bet on a uranium mining play and I'm 50% down and 2 years in.  I still think it will come back and I will have a good return, but if I needed that money I'd have been in trouble.  That is your risk, you have no fall back position, so you better be right.

Michael Seeker · Answer

You hit the nail on the head - I would never put all of my eggs in one basket with the hope of appreciation.  If you're in a negative cashflow situation, you may not have enough time to wait for appreciation to bail you out.

Many of the RE investors who lost everything during the bubble were overleveraged on any property they could find without enough (or in a lot of cases any) money coming in to pay for it, then the floor fell out and they lost everything.

A simple litmus test is how long would you be able to handle the payments if it were vacant?  A couple months?  A year?  Doesn't matter...you can afford it?  Appreciation is nice, but I'd focus more on worst case scenarios than silver linings.  That way you're prepared for the worst and will likely see better than expected results instead of the other way around.

Account Closed · Answer

J,

Now that I read your thread a little closer, I have a couple of questions.

1) what's the asking price?

2) what's current rent?

3) what's the pro-forma rent?

4) how's the school district of this duplex?

5) just for kicks, how young is this duplex?

I just want to put things in perspective for the readers so they can appreciate their markets. ;)

Account Closed · Answer

Bryan,

There's a sucker born every minute. Also, some people have way too much money to know what to do with it. Like some individual paid $3.2M for a classic car or $100M for a painting.

The reason they're asking for a 2.5% cap because that is what the market is willing to pay. I know it's nuts, but it is what it is.

Account Closed · Answer

J,

I see positive cash-flow here. If you bank with East West Bank, they will loan you $1M at 1.99% on every $1M that you have in your bank account. Wow, positive cashflow with a 2.5% cap.  :)

Amit M. · Answer

J. Martin

The duplex you were referring to will probably sell to an owner occupier or a flipper. It's hard to buy and hold in SF unless you: have a sizable down payment, can ferret out a good off market deal, or can find a clever value added play that will increase the income after development.

But other than that yeah, only an idiot would invest in San Francisco ;)

Bill Gulley · Answer

Here might be reasons for low rents and cap rates:

Property is leased to a family member, might be a cousin or family friend.

It was purchased in a lease back agreement as part of the deal.

An owner just turned landlord as a means to get out from under a mortgage and moved on.

The property can be leased to an investor on a master longer term lease, lower rate for lower risk of vacancies.

The lease could be showing, the option on the property may not be obvious.

Properties may be leased under non-profit programs, again a source of guaranteed rents for lower returns.

Owners may have plans to move back to a property, lower rents to tenants who may be more trusted as consideration for caring for the property.

I know a car dealer who has rentals, some of his employees rent from him at break even amounts.

Transitional housing arrangements, I buy your house, might be taking your house, I'll allow you to move into this one at a good deal in order to get into the other property being acquired, giving that owner more time to relocate.

Properties can be providing other benefits to an owner, as I mentioned above, other than seeking cash flow, there are many instances where money isn't everything. :)

Bill Gulley · Answer

That said, it might have cash flow, but 2,5% certainly isn't something to shoot for, you may end up with that, or less. I probably committed the investor's ultimate sin for a small investor, I bought a 2bd rock cottage, nice size rooms with a basement, detached oversized 2 car with second floor large attic, that was never rented for over 8 years. Utilities on, heat and air. It was heading to a foreclosure and through a divorce. Long story about it, but work was done on the property along the way, nothing major, just paint, polish, small issues, carpet, stenciling just messing with it. I put a sign in the yard, NOT For Rent or Sale!  There was a reason it was held, training for labor type owners getting into other properties. When we didn't need it, a Realtor bought it for her home, 115K, 40K down 5 year note (she made the offer and I took it). I bought it for 40K. I know there was less than 3K in fix ups, probably 14K in holding costs. 5 years of 10% interest and she paid it off. Not so bad for the sin of not renting it at all. :)

Is 2.5% a good cap rate? "Gambling" on appreciation?

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