Cap Rate is Just a rule of thumb
There is quite a bit of confusion on the subject of Cap Rates or return on investment. Seems like most residential brokers just work back wards into a Cap Rate. I mean set a price and then divide the "Net Operating Income" by the sellers value. The listing broker usually will just ask the Seller this question, "What Do You Want for a Price". Now, that is just not how it is done with investment properties. Investments are like the stock market. The stock broker never calls the investor up and says, "What do you want for your stock"! No, the stock market is market driven and investment real estate is market driven. I think I am correct in saying that the reason a person would invest in real estate is to make a profit, not a killing, but a profit. Now that is where the rub comes in. Un-savvy real estate brokers and sellers, tend think they are selling too low and their property is always worth more. Buyers always think the price is too high! Often times seller, broker and buyer are not trained in how to establish value of an income stream. They are either un-aware of the market, want to make a killing and hope the broker is a miracle worker, or just rely on the broker or their own concept of value or their buddy to price the investment.
Here's the deal!, if you pay too much, it does not matter what the Cap Rate is. Also, if you price the property to high, most astute investors will ignore the investment and move on to one that makes sense. What matters to an investor is the amount of money that will be put in their pocket each month and that is where the true worth of an investment is measured. Rate of return is based on several things and starts with what is called the "NOI" Net Operating Income, that is what is left after Vacancy and Expenses of Operation. With NOI a person will pay debt service. Now after you use the NOI to make the mortgage payment you will see what is left over at the end of the month, and this amount or lack thereof, will determine the cash flow before tax. "Cash Flow Before Tax is just that!, The tax man must be paid before you are entitled to a return or a profit. Now the "After Tax" cash flow must be figured. Then truly you will be able to put the cash left over in your pocket. So; Gross income, less Vacancy, Less expenses, Less Debt Service, Less Income Tax, will be yours to spend.Be sure there is some left, cause the tax man, the City utilities, the property tax and insurance people do not care if you make a return, they still get paid.
Numerous times there is nothing left after expenses and debt service. Did the broker or the seller try to tell the investor that this thing will never make a profit, because the rents are maxed out? Did the broker try to tell the Seller that an investor will not pay that much because there is nothing left over at the end of the month. Did the Broker tell the investor that taxes and expenses go up, but not at the same rate as income? Probably not!
All parties to a transaction need accurate income and expenses and then based on the purchasers goals and requirements a price and rate of return on the investment can be figured. The listing brokers obligation is to inform the seller that a purchaser will not buy an investment with no upside or big risk and low cash flow. A bank certainly will not finance an overpriced listing or a risky investment. Banks use a tool called "Debt Coverage Ratio" which means that the "Net Operating Income" must be a certain amount bigger than the debt. Usually that Debt to Income ratio is 1.20, 1.25 or 1.15, depending on several things. In other words the NOI must exceed the debt by 100 percent plus 25%. So a 25 % cushion. If rents went down or expenses went up the cushion will still allow the mortgage to be made. Banks and risk! what a novel idea. They measure the risk quite well and will for the most part will not loan on a risky under preforming deal. If they do the risk will be in their favor and you may put up 60% of the money instead of 30% of the money. Its all about risk!
Hire a CCIM (Certified Commercial Investment Member). I am available for people wanting to sell or purchase or in need of expert testimony in court cases involving income producing properties.