Cap Rates, Bond Yields, GRM and Expressions of Risk

I go to real estate networking events obsessively. As a result, I hear a LOT of pitches. Something I hear oft repeated by those presenting is that it doesn't make sense to invest in California because of the low cap rates.

Before I begin: I am not writing this blog to challenge the assertion that California has low cap rates. Yes, I know, they're low.

I am writing this post to explain what cap rates can tell investors about the market they're investing in.

The equation for Cap (short for capitalization rate) is (Net Operating Income)/Purchase Price. In most markets listing agents will estimate the Net Operating Income (NOI) as 35% of the Gross Income of the property.

(Based on my experience these expense numbers are often fudged to make the deal seem more attractive than it actually is to attract potential investors).

Investors like high cap rates because they show the potential rate of return for the investment. Conventional thinking is the higher, the better.

What else do cap rates tell us?

Let's talk bond yields for a second - specifically 'current yield', which equals the annual earnings of the bond divided by its market price. (Note the similarity to the cap rate formula!) In finance high yield bonds are often called junk bonds, since they lack the credit worthiness of treasury and municipal bonds.

Take a moment and Google the junk bond crises of the 1980s for additional information on the dangers of investing heavily in junk bonds.

In real estate investing in high yield properties, while in theory sounds great, is similar to buying a bunch of junk bonds for your portfolio! You're putting your money at risk!

I always ask my clients to follow a certain thought exercise when I'm helping them see the insanity of chasing yield in the middle of America with their hard earned money.

• Before we begin the thought exercise let's talk about Gross Rent Multipliers or GRM.

The formula for GRM is purchase price/gross scheduled income. When I go to networking events that over simplify equations they tell the audience that the GRM doesn't matter since it only shows investors how many years it takes the gross scheduled income to pay the purchase price of the property.

The GRM can tell investors much more though. Let's say we purchase a property for 100k and the gross income on the building is 10k. If we calculate the GRM (100k/10k) we can reduce that to 10/1, or say it's trading at 10 times gross.

In laymen's terms we are paying $10 for every $1 of income the property generates. Or creating $10 of equity for every $1 we're able to raise the rental income.

Let's take two separate investments -

• Apartment #1 is located in the middle of America and has a great cap rate! We're able to buy it at a low GRM and since the purchase price is low we get great cash flow. The apartment building is right next to a large factory/mine/facility of some sort that creates a ton of jobs in the area. (High Cap Rate, Low GRM)
• Apartment #2 is in a coastal community. Our cap rate is horrible, and since we don't generate a ton of income, our GRM is really high. In fact, if we have a vacancy we'll have to supplement the income to make sure the mortgage is paid. (Low Cap Rate, High GRM)

If we compare the two, the flaws in each our obvious. If the factory closes near Apartment #1, we'll lose renters, and won't be able to pay our mortgage. Apartment #2 is so expensive that we're not always sure our tenants will cover our mortgage.

How do investors mitigate their risk?

Don't chase cap rates! If it sounds to good to be true it probably is...think about cap rate like an expression of risk when evaluating property. Don't treat it like a guarantee of money in the bank.

Happy Investing,

John