## Investment Property Cap Rate, What You Need to Know

Many investors have a problem with determining what offer price to make for mufti-family properties. I am not talking about a single family home (SFH) being rented but pure rental income properties. Hedge funds have been buying SFH’s like crazy not because the yields are great, but because of eventual price appreciation when they resell them as SFH’s.

For the investor who wants passive income from rents, what are the two ways he can determine what offer to make to a seller? The traditional method is to fill out a long form of expenses carefully calculated so the annual income less these expenses then equals the net income on the property. This net income figure is them divided by the net cost of the property to the investor and the result in a percentage (%) format is called the CAP Rate.

You’ll hear sellers telling you that the rents are well below market value or the property is within walking distance to the beach – that doesn’t matter. All that matters is how much net income you as the buyer can receive starting when you close. Sure you may be able to raise rents but what if you can’t? Stick to your guns and buy what you see and you deserve the bonus of higher rents if and when you can get them.

The second method is what I’ll call Dave’s 5 Second CAP Rate. Using this method, it shouldn’t take a buyer any longer than 5 seconds to determine what price he wants to pay for the property. The premise is very simple, in the good old days a landlord was happy to receive 1% per month of his purchase price which correlated into approximately a 10% gross rental income.

For example, if you paid $80,000 for a property and you received $800 a month income, your gross rental income would be $800/$80,000 = 1% monthly income. But what was your CAP Rate at this rental income? Typically if the landlord had reasonably good cost controls in place he could deduct 2% to 3% off the 10% for a CAP Rate of 7% to 8%.

Dave’s 5 Second CAP Rate calculations use a reverse equation that takes a divisor factor and divides that number into the Gross Monthly Income to get a close approximation to the actual CAP Rate without knowing expenses or condition of the property.

In 2008 to 2011 we used a divisor factor of 0.03 or 3% to give us CAP Rates in the areas of 25% to 27% net income! Between 2011 and today we have been using a divisor of 2% for CAP Rates of 16% to 17%. If these income figures sound astonishing I understand because you are trying to buy income properties from people who aren’t really motivated to sell. Many new landlords are comparing what their money sitting in the bank would yield versus what is a seemingly high rate to 8% to 9%+.

For example, I first determine that the Gross Monthly Income (GMI) on a duplex, triplex or quadplex is $3,000 – remember the number of units doesn’t matter, just the gross monthly income. I next divide the $3,000 by my divisor of 2% which looks like this:

$3,000 / 0.02 = $150,000 is my offer to the seller. This represents an approximate $17% to 18% CAP Rate. That’s all there is to it.

What about condition? What about “sweetheart leases?” What about how close it is to the beach? None of this matters because all that matters is what is the GMI of the property. But the condition is so bad that there are no tenants?

In this case you’ll need to determine what usual rents would be in the area, calculate your CAP Rate offer (2% divisor) and then subtract your repair costs. Will this be a ridiculously low price? I hope so or you will become one of the 80% of landlords who lasts less than 3 ½ years in the business.

If you have so much money you have to put it to work, think about what hard money lenders can make – at 3 points and 12% interest on each $100,000 if loaned twice a year, they will make $100,000 x 3 points (3%) x 2 (twice a year) = $6,000 plus 1% per month or another $12,000 a year for a total income of $18,000 or a CAP Rate of 18%.

If you work it right you can make another couple of thousand dollars on junk fees charged to the borrower – all secured by a first mortgage and with the borrower putting 20% plus equity in the deal. That’s without tenants and toilets or the liability of tenants suing you because of something they blame on you.

But what if you only have 10% or 20% of the purchase price to buy the property? That’s easy, find private money (friends and family members) who will loan you money at 6% to 8% simple interest which is many times what they are getting in the bank.

Here is what we do – we buy at a 2% divisor factor and try to sell at a 1% divisor. This looks like $3,000 GMI / 2% = $150,000. Next we try to sell at a 1% divisor or $3,000 / 1% = $300,000. What if that doesn’t work as we hoped for, we might pay as much as $175,000 and sell it at only $225,000.

Well, then it’s not the greatest deal but it is a $50,000 profit without any tenants or toilets and often using double closings the same day and as we always try to do, with no money in the deals as we use transactional funding or legally use the end-buyer’s funds whenever we can.

To your limitless success,

Dave Dinkel