Cap rates are the first value you should inspect when inspecting a property. In my opinion, the cap rate is more important than the neighborhood, the number of units, or the price of the property. The cap rate tells you what your return on investment would be for an all-cash purchase.
Over the last six months, sixty-six 3-plexes and 4-plexes sold. Look at the chart, and you will see that the bulk of these sales occur at 0.06 and 0.08 cap rates. These are the two focal points of the current market.
Using Cap Rate to Sell
If you are selling a property, you want to price your property at 0.06 cap rate. This rate reduces the buyer’s return because the purchase price is higher. That means that if the buyer takes your property, you will pocket more cash. 0.06 is the cap rate you want to sell at.
To attract an eager and willing buyer at 0.06, you want to represent your property as being recently rehabbed. Use 3D tours and recent interior photographs to show the property is well maintained and in impeccable condition. “Wood-look” flooring (often glue-down LVP) and solid-material counters go a long way toward conveying “like-new” to buyers.
Using Cap Rate to Buy
If you are buying, you want to buy a property at 0.08 or more.
The quality of the property is a concern. The higher the cap rate, the better your return. But, higher cap rates also usually mean that the property is in disrepair. Whether the neighborhood, the property, or the tenants are causing the seller to price the property comparatively low to attract buyers. If you are willing to take on some of that risk, you will be rewarded for it.
Properties that sell at 0.08 are a reasonable compromise. At this level, the neighborhood is “good enough,” the tenants are “good enough,” and the property is “good enough.” The risks are reasonably balanced between high return and moderate risk.
0.08 is the ideal purchase price, because it shows consideration from the seller that the market has risk, and it shows appreciation from the buyer that will accept a reasonable return rate on their cash investment.
When you are financing your deal, cap rate turns into a higher ROI
Cap rate gives you the return on investment for an all-cash purchase, but if your only investing 20% of the property value, then your return is usually higher.
The easy way to determine if your ROI is higher than your Cap Rate is by comparing the Cap Rate against your interest rate. When the cap rate is higher than the interest rate, you are making money on the dollars you borrow from the bank. This increases your return by using “OPM” (Other People’s Money).
An Example Where You Profit on Borrowed Money
For example, consider a property that has a 0.08 cap rate. If the annual percentage rate on the mortgage is 6%, then for every dollar that you borrow, you are spending $0.06 per year in “debt service,” but you are earning $0.08 in net income. In this scenario, you profit $0.02 for every borrowed dollar. If you borrow $100,000, you are making an extra $2,000 per year on the money you borrowed, and that infinite return raises your ROI.
An Example Where You Break Even on Borrowed Money
As a counter example, buying a property at 6% APR with a 0.06 cap rate evens out. For every dollar borrowed, you earn 6 cents and you spend 6 cents. Your net gain is $0. This is why we see the best properties selling at 0.06 cap rate.
We see the best properties selling at nearly the same rate as the available mortgages, because buyers want to own the property so badly (compared to other available properties) that they don’t care if they break even on the borrowed money.