The CAP rate is a good starting point to determine if you have a deal!

You did it! You finally found a seller who said they want to sell their property. Now you have to determine if they are motivated. The only way that you can buy a property is if you have a motivated seller who is willing to sell their property to you at the right price. If they want to much for the property, you will not be able to make a profit or cashflow.

When you are looking at a property, you want to verify that there is a way to either get the property at a discount, a below market cap rate or you want to make sure that there is some way to increase the value of the property so that you can increase the value of the property when it is time to refinance or sell the facility. By increasing the value of the property, you increase the cap rate down the road.

To determine the cap rate on the property you need to see the profit and loss statement on the facility. When you look at the profit and loss statement, make sure that you evaluate their numbers carefully. They may have lower expenses than you will because Uncle Bob is currently taking care of something for them in exchange for 3 large units. Those units happen to show on the books as being rented and bringing in income. Make sure that the expenses are reasonable and that you will be able to continue to operate the facility at the same rates. If not, make those adjustments. A typical expense amount across the nation is 35%. Your facility may be higher or lower, but if it is grossly different, make sure that you verify.

When you look at the income, understand that some of those units are being rented to friends and family and there will be an exodus when you take over. You might want to reduce the income of the facility to take this into account so that you are not surprised when your income goes down initially.

Now you need to evaluate what the upside potential is on this property. What will the CAP rate be when you are finished with it? Are you going to add more units? Are you going to be able to fill more units because of better management and maybe a little TLC? You may discover that a property has a terrible cap rate, but the upside potential cap rate is so great that you buy the property anyway. Always look at the upside potential cap rate as well as the current cap rate.

Now that you have your 2 CAP rates, you need to determine where they lie in the current area’s market. If it is higher than the average, then you have possibly found a good deal. On the other hand, if it significantly lower, then you are going to need to negotiate with the sellers to see if this is something that you might be interested in. However, the only way that you will know is if you are researching what the current rates are in your area or your area of interest.

CAP rates are not the same throughout the country. Make sure that you know what your target is and then stick to it. If you can get a better deal than you want, that is great, but don’t get caught up in the moment and agree to a deal that isn’t actually a deal. CAP rates are not the be all end all to determining if you want a property, but they are a good starting point. As always, happy investing.