Special offer

10% Capitalization Rate in Residential Real Estate?

By
Real Estate Agent with The Virtual Real Estate Team 104556

Sometimes I have people who ask me what is the cap rate of a residential rental property. Normally that is  the wrong question. A capitalization rate is a way of finding value based on the net operating income. That is income before interest and taxes. It is most often used in commercial real estate where value is more driven by rental rates than appreciation which is where residential real estate gets its rate of return on a long term hold. Simply put, if after expenses you have a 10,000 net operating income and you figure it on a ten cap then the property is worth $100,000. When buying a new property to rent your first year cap rate will not be as high as your five year when figuring value, if the market is appreciating. We are starting to here more questions like this in residential because people are unsure of appreciation in a national market downturn, and the investor wants income up front. In that respect it can be the right question.

So how do you get a cap rate of 10% or more in todays market? First you have to find rents that are considerable higher than the purchase price. For instance, if you buy a $150,000 property and the rent is $1250, then after an 8% to 10% management fee, and maintenance cost, a 10% cap rate is not possible. That does not make this a bad buy in Oklahoma because we are appreciating. Where 10% rates exist is in lower price ranges, typically below $80,000. Let's take a $60,000 home in a decent neighborhood, you can expect a rental rate of $700 per month. If property management is capped at $50 per month, and the home is in good condition with recent capital expense upgrades, then maintenance and property management will be low enough that a 10% rate can be achieved. An advantage to buying this type of property is that rents compress on the low end so that going $20,000 lower on a purchase may result in only a $50 per month drop in rent. Another advantage is that many more renters can afford payments so you have more renters than property available, and very low vacancy rates.

Tomorrow I will blog about examples of these types are properties that are currently available. We have 30 homes under $80,000, many with granite counter tops, new appliances, all tile floors, and updated central heat and air. 24 of them are currently rented and the management fees are 10% with a maximum of $50 per month regardless of price. We also have a property manager that personally picks up rents due so the properties are seen every month. If you want to be put on a list of available rental homes, please email me with your criteria at joe@joepryor.com.

Comments (4)

Anonymous
Sam

Joe,

Thank you for raising the concept of cap rates in regards to residential real estate. However, I think you miss the point a bit on the role of cap rates in all residential transactions. You say "[A low cap rate] does not make this a bad buy in Oklahoma because we are appreciating"

You are using an appreciating market to justify a low cap rate. So why is the market appreciating? No matter what answer you provide, (e.g. growing job market, crime rate going down, etc) those features should also be causing the rents to rise. In other words, greater demand for housing should make rents and prices increase in approximately equal proportions (unless some outside factor, like too-low interest rates and loose lending standards) causes this parity to get out of line.

The bubble that formed nationwide could have been prevented if buyers everywhere had the financial literacy to understand the link between rents and price, even if they have no intention of renting out the property. What's the alterntaive? Comps-- unfortunately real estate brokers and mortgage lenders have been teaching home buyers that the most important determinant of the value of a house is what the guy down the street was willing to pay for a similar house! What if the guy down the street is an idiot? "oh, well, we get 5 comps... so plenty of data" Just ask the people in CA and FL how well using comps worked out for them.

Any market that has cap rates in mid-to-low single digits has overpriced housing (unless there is some outside factor like rent controls that keep rents artificially low).

When prices finally reach 8-10% cap rates, then the real estate market can start its recovery. Let's continue educating home buyers so that this can happen as soon as possible.

Feb 24, 2009 06:15 PM
#1
Anonymous
Joe Pryor

I appreciate you adding to the discussion on what is not generally understood by residential Realtors. The point I was trying to make is that commercial is heavily dependent upon rents and net operating income to determin value. Residential can pay off if you buy right at a low price ad even if the cash flow is neutral or slightly nbegative, you can on a long term hold benefit greatly on accumulated wealth if you are patient about the return of appreciation. I also agree with you competely about how comps can be manipulated and not show true value. As a Realtor who was previouly certified as an appraiser, I look at high comps that are outside the norm and throw them out. Too much investment has been based on the greater fool theory. Now that the bubble music has stopped, those fools are non-existent. Fortunately, you can buy 10 caps in Oklahoma, and yes the rents are rising. We lead the nation last year as a state for the rise in average and median price increases, and 2009 should be a flat year for appreciation and in this environment that is a triumph. You comments are reasoned and right on and I thank you for your contribution.  

Feb 25, 2009 02:07 PM
#2
Mike Crosby
Mike Crosby Realty - Placentia, CA
Placentia- Yorba Linda Real Estate - 714-742-2897

Hello, this is an older post. what is the market like today in 2013?

Apr 13, 2013 12:08 PM
Joe Pryor
The Virtual Real Estate Team - Oklahoma City, OK
REALTOR® - Oklahoma Investment Properties

The market is flying, Mike. In the better suburbs we are running a month month absorption rate, and the rentals are typcially at a 1% vacancy rate with a 3% maximum for anything above $1000 a month. We had no meltdown, only a correction, we have run an annual population growth rate that is double what is typical for the last five years, and we are leading the nation for cities over 1 million with the biggest growth in personal income matched with a 4.5% unemplyment rate and dropping. The key is to find the good properties.

Apr 13, 2013 12:59 PM