When to ignore the cap rate

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Have been looking at listings for mid-size apartment buildings today and ignoring the cap rates.

Why? Isn’t cap rate the thing you should care about with investment real estate?

Not when you’re working with brokers who don’t have a good grasp on calculating cap rates.

Here’s an example:

  • Looking at a 10 unit deal priced at 12.8x GRM (in other words, 12.8 x the total annual rent)
  • Broker is calling it a 6% cap rate
  • Let’s do some math…
    • Assume rents of $100k / year
    • That means the price is $100k x 12.8 = $1.28MM
    • At a 6% cap, that means the net operating income is $1.28MM x 6% = $77k / year
    • With rents of $100k / year and NOI of $77k / year, that means expenses are $23k / year

That’s the point I call “bullshit” on the broker.

If you buy this building for $1.28MM, your property taxes alone will be $16,000 / year. On a 10 unit building that’s, say, 7,000 sq ft, your insurance will easily be $4,000. That means you’ve got $3,000 left to cover utilities, management, vacancy, pest control, repair reserve, etc. Bullshit.

What’s the real cap rate on this sucker? Honestly, my guess is that it’s a 3-4% cap rate… awful.

And that’s why you ignore broker-quoted cap rates. Most of them don’t know what they’re doing, and you should not get lured into their world. After all, when the deal closes, the broker goes home with his commission. You’re the one living with the 3% cap.

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