Throughout the United States, cap rates for rental properties may range from less than 4 percent up to 12 percent, 14 percent, or higher. Generally, a low cap rate occurs when you value highly desirable properties in good to top neighborhoods. Relatively high cap rates tend to follow less desirable properties in so so neighborhoods. Apartment buildings with condo conversion potential tend to sell with low cap rates. (Remember, a low cap rate translates into a relatively high value, and a high cap rate produces a relatively low value. ) If you find that across all types of properties and neighborhoods in your city, cap rates in your area are too low (i. e. , prices are too high), search other areas.
High cap rates (lower earnings multiples) may offer lower risk and higher cash-on-cash returns. Stock market investors may see the parallel between cap rates and P/E ratios. If a property sells with a cap rate of .085 (8.5 percent), that figure would represent a P/E multiple of close to 12. Conversely, a stock with a P/E multiple of, say, 14 would show an earnings yield (cap rate) of 7.1 percent (.071). Either way, these similar techniques both try to show the relative valuation of a stream of income. With stocks, a stream of corporate earnings-with real estate, a stream of rental earnings. Likewise, over time these yields will move up or down according to the strength of the economy, the outlook for interest rates, the potential for higher rents, the quality of the income, and various risk factors. No single cap rate can ever represent the “correct" rate.
You must investigate each property submarket. When you buy conservatively, you widen your margin of safety. Yet, you may run across a super property at a relatively high price. Should you automatically reject it? Not necessarily. But before you buy, check, verify, and recheck your
optimistic expectations. Sometimes a “fully valued" property with extraordinary potential will outperform a bargain-priced property with very limited upside. When you buy high, know the risks. Unnoticed perils have brought down many a sure thing. Does your market data on the local
economy, your target tenants, and competing properties (rents, features) truly support your plans to grow the property's NOI?
Step-by-Step, Affordable Training Videos on How to Build or maintain a Powerful commercial property Portfolio, covers land, apts, multifam, retail and more!
By: Raymond Pedersen