Keep in mind a low cap rate means a high price. Cap is the relationship of the cash flow to the price. If the cash flow is low, relative to the price, the cap is low. As a result if you start at a 4.5% cap, the rents stay the same and the value goes up, the cap will go down. If you buy at 4.5% cap it means you may have to wait a very long time for the property to be worth more unless you can raise the rent. California real estate has for a long time had low caps (high price, low income). People invested in such properties because there was a (false) notion that California property would always go up. Investors were therefore betting on future value rather than income flow. San Diego was one of the first places to see price drops (caps going up) in Southern California. I would suggest you would be paying way too much for a property with a 4.5% cap? I have property listed that carry an 8 cap with tenant paying all expenses including taxes, insurance and maintenance. They have automatic rent increases in the future. Keep in mind cap is only a measure for 1 year. It does NOT include debt. A property with a 4.5% cap will not break even with 30% down. A property with an 8% cap will have a positive cash flow with 20% down. A better method for determining what has value and what does not is internal rate of return (IRR). IRR takes into account multiple years of cash flow, all expenses and debt service (remember cap is 1 year and no debt service and the lower the cap the higher the price). Cap is very easy to figure (probably why it is used so much) while IRR is much more difficult. In addition to IRR one should look at capital accumulation (CA). Simply stated capital accumulation is the amount money that is accumulated during a holding period? IRR is a percentage CA is cash. If you would like more information or an comparison example please send me an emal at email@example.com or call me a 626 485-5163. If you email me be sure and put something in the subject line so I don't think it is spam.
Apr 1, 2009