Recently, I’ve been hearing people toss out some strange phrases like:
“I don’t buy anything unless it’s 12 cap or higher.”
“5 cap is too low, there is no value.”
But, I passed over a 12 cap deal and I bought a 5 cap deal just this year.
So, what capitalization rate is good?
Understanding Cap Rates
Just as a quick refresher, go check out my article on cap rates.
More important than understanding what a cap rate is, it’s important to understand how it works.
Cap rates are just another way to evaluate risk.
A deal with a very high cap rate would be considered riskier than a different deal with a lower cap rate. So, in essence, when someone says a “5 cap is too low” they are saying “this deal is too safe for me.”
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Deals With High Capitalization Rates Often Have Significant Problems
When the going cap rate for a particular deal type is 7% and you find a deal at 15%, you have to ask yourself why.
There is a reason no one will buy it at a 7 cap! It might be in a terrible neighborhood, have a history of problems, or have structural issues.
The other major concern – when it comes time to sell, will you be able to get the same or lower cap rate, or will it be higher?
If you’re buying at a 15 cap, you’re very unlikely to sell it at a 7 cap. It could happen, but it’s really unlikely.
Let’s say the city your in has C-class property trading around an 8% capitalization rate and you find a sweet deal at a 12 cap! It’s fully occupied, fully stabilized, needs almost no work, and they will trade it for a ridiculous 12 cap. Sounds like a steal, right?
I recently looked at a deal very similar to this. I got there and discovered a lot of very serious deferred maintenance – roof, siding, etc. Also, it had some structural issues that needed to be repaired. So, though the property was fully stabilized, the amount of work required is why it was trading at such a high cap rate.
And, even if you could turn around and sell it at an 8% cap rate, the deal still wouldn’t have made any money.
So, high cap rates don’t always mean good deals.
Deals With Low Cap Rates Aren’t Always Desirable
On the other side of things, low caps don’t always signal a safe and desirable deal.
Sometimes a deal has a low cap rate because it’s significantly underperforming. Deals with a ton of upside potential will sell for a very low cap rate compared to other properties that are performing properly.
Let’s say a C-class property is generally trading around a 7 cap in your area. So, a deal with an NOI of $100,000 would sell for around $1.4m.
Let’s take another deal that has been severely mismanaged and is half vacant. It’s structurally OK, needs some minor repairs, but really just needs some new management and new policies. It’s NOI is only $10,000 (if it’s lucky), and more often than not it’s losing money.
Would you expect this apartment building to sell for $140,000?
Of course not.
Realistically, the cap rate would be pretty close to zero because of how low the NOI is in this example.
I used this as an extreme example, but the point is to illustrate that low cap rates don’t always mean bad deals with low cash-flow.
What is a Good Cap Rate?
Getting back to the question at hand – what is a considered a good cap rate?
If your goal is to buy a full stabilized asset, you should look for something that is trading for about what is average in your area.
Instead, If you are looking for a deal where you can potentially add value, consider looking at deals that are trading at a LOWER cap rate.
If you want deals in problem areas with high potential cash-flow, but aren’t focused on the value-add, then consider deals with high cap rates.