Want higher ones, right? I don’t.
Confused? I don’t blame you. You heard me right. I am just recently more impressed with 7-10% cap rates than 12%+ cap rates. I’ve had just enough experience in the rental property world to teach me that there is some real value in not ruling out those lower cap rates!
What is a Cap Rate?
A cap rate is a measure of the purchase price of an investment property compared to the net income you make from that property. If you pay all cash for a property, it’s the measure of how much you make on the property compared to how much money you put in, which is the same as your cash-on-cash return. If you finance a property, your cap rate is different than your cash-on-cash return. Cap rates are the general calculation done on most investment properties to give the buyer an idea of how good the investment may be, so for now, I’m sticking with those.
The Cap Rate equation:
Annual NET Income / Purchase Price = Cap Rate
Today’s Rental Market
It’s hard to say what a good cap rate is. In general, I would say anything over a 6% cap rate is potentially a good investment (I say potentially because there are of course other factors involved). This goes for residential or commercial, big or small.
For single-family homes and duplexes today, with the market where it is, my observation is that rental properties are ranging from 6% caps to upwards of 20%. Of that range, I would say 6-15% is with more expensive homes or turnkey rentals. Higher than 15% and you are most likely dealing with fixer-uppers. For the purposes of this article, I’m going to stay focused on the turnkey rentals since those are what I deal with personally, plus it keeps things more simple because going into how rehabbing affects returns is more complicated than the point I am trying to make. So I’m going to address the 6% to 15% Cap Rate range.
Higher or Lower Cap Rate?
Various factors go into what makes a good investment property. What condition the house is in, what area it is in, the kind of tenants most likely to move into it, your exit strategy, and the list goes on. As I continue to work around rental properties, I’m noticing more and more the patterns between purchase price, cap rates, and quality. The cap rates in various markets are starting to merge due to the upswing of the general real estate economy (in my opinion), but there are still fairly clear distinctions between what markets can give you what cap rates. If someone tells me they want the highest cap rate possible, I steer them to one market. If they are more concerned with quality and appreciation potential, I steer them to another market. Every once in a while there is a market that has a great combo of all things awesome- high cap rates, high quality, and high appreciation potential. For example, Phoenix about three years ago and Atlanta about a year ago. There is a reason why the institutional funds and investors flooded those markets! Outside of those rockstar markets though, there is a lot more distinction between your options.
With some exceptions, here are my general observations between the higher and lower cap rates in turnkey world, so the difference between 6% and 15% (and these are very generic assumptions and vary between the markets):