- We as human beings share an almost universal trait – we want to look for the simplest explanation. In the case of real estate investing, we might be tempted to rely solely on the cap rate.
- Our minds evolved to quickly reduce problems down to a simple plan of action that would get us what we were after – a meal, shelter, an ally.
- Often, the simplest explanations are true. They are certainly more convenient and easier to understand.
- However, in our present-day circumstances, we are often required to evaluate a sea of information and factors that work for and against each other.
- When we invest money, we are looking for the rate of return, correct? For income property, that rate of return on our money is the cap rate, expressed as a percentage of the initial cost of the property. Buy the one with the highest cap rate, and you will make the most money, right?
- Well, not so fast. Have you considered:
- Cap rates can be easily MANIPULATED!
- A property will have a higher cap rate if the expenses are understated, possibly by leaving out the true cost of maintenance and eliminating property management altogether.
- Can anything be done to increase the cap rate after we purchase, by lowering expenses or increasing rents?
- Are cap rates in the same area/neighborhood similar? If the building we fell in love with has a high cap rate of 6.5%, and all the other buildings are at 5%, you can bet some added risk is being priced into the sale.
- A building with bad tenants and lots of deferred maintenance should be priced at a higher cap rate, due to the risk the new owner must take on.
- Besides the cap rate, cost per unit, cost per s.f., the Gross Rent Multiplier (GRM) are also very important parameters.
- Getting a feel for the building, its tenants, the neighbors and how units are renting in the same neighborhood are vital factors to also consider before committing your capital.