Home > Uncategorized > Answers To Real Estate Investment Questions – What’s The Better Deal?

Answers To Real Estate Investment Questions – What’s The Better Deal?

December 9, 2010 Leave a comment Go to comments
Last month I wrote back to back posts posing questions for real estate investors — without answers. I promised you wouldn’t wait too long for the answers, at least what I think they are. Today we begin. If you’d like to review, or haven’t yet read the questions, you can go to Here Are Some Questions — What Are Your Answers.Let’s get going.
 
Question #1 
You have two income properties from which to choose, but only enough capital to buy one. Property A offers a cap rate of 12.4%, while Property B’s cap rate is 7.8%. Which one is most likely to be the best long term acquisition? Why?
The answer to this question is one of the most common stumbling blocks to new and/or relatively inexperienced investors. It’s somewhat of a trick question, in that the numbers give away the answer.
What I learned early on in investment real estate is that the higher the cap rate, the lower the quality of location.
Pretty soon you learn that double digit cap rates almost always are synonymous with bad neighborhoods.

Cap Rate: (Capitalization Rate) Is the NOI/Price (value). Another way to think about it — if you paid cash for the property it’d be your cash on cash return. Example: NOI = $10 Divided by $125 price = 8% (.08) cap rate.

Let’s take a midwest city like Dayton, Ohio as an example. The median home there is just over $100,000 or so. Same with duplexes found in nice neighborhoods.
Let’s say you found one for $100,000 with rents on each side of about $500 a month. That’s $12,000 a year in GSI (Gross Scheduled Income).
If we take away all operating expenses including vacancies and management, the NOI (Net Operating Income) might be, generously speaking, roughly $7,800.
If the market price is indeed $100,000, then the cap rate 7.8%.
But, what if you found a property a few neighborhoods away offering the same $500 per side rents, but for a 12.4% cap rate?
What would the price of that duplex be?
Pretty simple, only this time, since you already know the cap rate is 12.4%, you divide the NOI by that percentage to arrive at the price. $7,800/.124 (12.4%) = $62,900.
Warning: Trap about to be sprung.

Same income, much lower price. This hasta be a no-brainer, right? Exactamundo. Pick the higher priced version and thank me later. Here’s why.

Ask yourself the question screaming to be asked: Why on earth is that owner selling for over 35% less than the other guy when the income and condition are the same?
Cuz the neighborhood sucks like a turbo charged Dyson, that’s why!! His tenants are nightmares.
His expenses and vacancy rate are much higher than the other one. Bad neighborhoods = lousy tenants = higher expenses/vacancy rates = higher cap rates = lower prices.
 
But wait, there’s more.
Have you caught the error in the numbers yet?
If the units are vacant a bigger percentage of the time, and the tenants are of significantly inferior quality, why would you assume the operating expenses are the same as the other duplex?
Helloooo?! They’re not. 
Bad tenants break stuff. They increase your repair costs. Your management costs. They generally live there for less time. You’ll learn all about the court system. This means you’re cleaning/painting/etc. more often.
 
All this to arrive at the real bottom line:
The lower priced duplex in the bad neighborhood doesn’t sport a net operating income (NOI) of $7,800 — not even close. As a matter of fact, you’re lucky if it’s $6,000 — which means — drum roll please — the real world cap rate is actually more like 9.5%. Since the area probably does command a 12%+ cap rate, the real value of that duplex is no more than $50,000.
In other words, not only did you not get a screamin’ deal at $62,900, you freakin’ overpaid by about 25%.
I take it back. It was a screamin’ deal — you’d be the one screamin’ once you figured out what a pig in a poke you’d actually bought.
The irony is that the high cap rate to which you were originally so enthralled, was itself a mirage.
It’ll be a management nightmare.
 
The Answer
Very high cap rates are seldom what they appear to be.
Buy the property sportin’ the 7.8% cap rate and be happy.
The property with offering the 12.4% cap rate is a sucker bet.
Don’t be that guy.
Reprint from Bawldguy.com  Dec 7, 2010
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