| Cap Rate Illusions |
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| Written by Allen Cymrot |
| Friday, 24 July 2009 16:27 |
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"How can a cap rate in the mid to low single digits sustain an investment in properties?" This was a recent question asked by a real estate investor when brokers in the area categorized current capitalization rates as normal. To answer the question a theoretical investment model must be formulated. The factors that play into this model are the investment amount, cap rate, lending rate and amount of leverage. Assuming the capitalization rate is 5%, the lending rate is 5%, and the property is 100% leveraged, this will provide a net cash flow of 0. Although this is a theoretical model it will provide the basis for our real-life example.
"How can a cap rate in the mid to low single digits sustain an investment in properties?" This was a recent question asked by a real estate investor when brokers in the area categorized current capitalization rates as normal. To answer the question a theoretical investment model must be formulated. The factors that play into this model are the investment amount, cap rate, lending rate and amount of leverage. Assuming the capitalization rate is 5%, the lending rate is 5%, and the property is 100% leveraged, this will provide a net cash flow of 0. Although this is a theoretical model it will provide the basis for our real-life example. Historically, risky or weak investments have often been marketed as normal, thereby lulling investors into a false sense of security. The Madoff scandal and collapse of asset-backed securities are prime examples of opportunities that appeared to be secure. Though the past is full of such examples, history seems to keep repeating itself. As the margins get smaller or the spread turns negative, the business of investing in real estate becomes less desirable. This lack of equity in the housing market also causes a negative affect on prices due to lack of demand. Good local brokers will realize that a negative spread is not good for the market. In today's market a capitalization rate less than the current market real estate investment mortgage rate will result in a negative spread on the property. This is a cardinal rule that should not be broken and is easily proven using numbers. If a property is generating 3.5% of the asset value, or $35 per month, and the cost to pay the mortgage is 5% of the loan, or $35 per month, assuming 70% leverage of the initial outlay, the result is a break even cash flow. So any changes of a negative nature will turn cash flow negative and render the investment moot. This baseline is typical and shows how thinly margined the business is as a whole. Leverage for real estate investors becomes quite a critical factor when the truth is revealed about how thin the margins are and how much initial outlay it takes to make money in this business. Why do income property investors need to leverage their investment? Income property is a single-revenue (rent), thinly margined, market driven, capital intensive, cyclical business with a fixed number of clients. To be yield competitive and attract capital, these characteristics dictate the need for income property investors to leverage. Cash-on-cash returns for income properties with a negative spread are not as attractive when compared to income properties with positive spreads. Consequently, income properties with a negative spread attract less capital. Less capital translates into market value atrophy. Experienced investors and responsible asset managers (not influenced by brokers) know this, and will not invest in income properties with a negative spread. When faced with thin margins or negative spreads, the upkeep and care of the investment becomes difficult. There will be a lack of capital for maintenance, marketing, and especially large scale improvements. These are the basic tenants for keeping the investment running for years. DISCLAIMER: This article is provided as information only and is not to be taken as financial advice. Allen Cymrot is a veteran investor and strategy consultant for real estate investment. His investment principles and recommendations for capitalization rates can be found at http://www.netgainrealestate.com Get a totally unique version of this article from our article submission service |
| Last Updated on Saturday, 25 July 2009 12:32 |