Hara-kiri is a traditional Japanese form of honorable suicide. Income property investors who rationalize why a 5% capitalization rate is okay are also committing a form of suicide. It’s investment suicide, and it is not honorable. Yet, investors continue to purchase income properties at a 5% capitalization rate. Why? Three factors guide the decision making mechanism for investors: (1) emotion, (2) intellect, and (3) a combination of emotion and intellect. Unfortunately, emotion plays too big a role.

All investments have their breaking point. It happens when the risks become greater than the rewards. Some investors believe that breaking points don’t exist for income property. A belief supported by nothing more than an emotional hope. Those people usually think that way because they’re not investing their own money, lack experience and/or don’t understand that income property like our economy is cyclical.

The emotional hype from this type of thinking almost always precludes understanding the mathematics of investment recovery. The importance of understanding the mathematics of investment recovery is predicated on its focus of risk. Simply stated, investment recovery requires a geometrically higher percentage to break-even than the percentage of decline.

Income property investors who don’t assess where the risks of buying property are greater than the rewards (the breaking point), and who don’t understand the mathematics of investment recovery are on a collision course with committing investment hara-kiri.

Why the concern? During the past several years, income property investors have driven down capitalization rates (cap rates). Buyers of income property who earlier vowed never to buy real estate below a 7% cap rate have been buying at 5%. Consequently, the accumulated volume of income property purchases at lower cap rates has forced investors to ask the question: When currently buying income property, is a 5% cap rate safe? The answer to that question, when one looks at the numbers unemotionally, is a resounding no it is not safe!

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The current economic downturn is different from others in the past. That difference is based on the civilian employment base increasing by 9% during the past eight years, while the national debt increased 89% during the same period.

Consequently, fixing this economy means not only making credit available and reconciling the toxic loans, it means increasing the employment base by a least 7.5 million persons. That type of increase only happens through a socioeconomic change, and that has happened only four times since 1776.

NetGain has continually analyzed, stated and cautioned that ours is a cyclical economy, and that recessions are a fact of life, and should be a part of every income property investor’s strategy.
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The United States continues its predictable and inevitable slide into a recession. For more information on market cycles, please reference NetGain’s essay “Market Cycles and Income-Producing Real Estate.”

Highlights of the current U.S. economy:

• The unemployment rate for October increased to 6.5% from the prior 6.1% rate for September
• The Consumer Confidence Index for October is 38 (1985=100), a record low
• The Commerce Department reported that the gross domestic product (GDP) fell at an annual rate of 0.3 percent in the July-September period, a significant slowdown after growth of 2.8 percent in the prior quarter

Current capitalization rate recommendation: Income property buyers should consider capitalization rates of 7% minimum. Included in determining the capitalization rate should be an attentive lease rollover analysis. The probabilities are that releasing lessees will be executed at lower rates.

Consequently, all income from leases that expire within one year has to be re-evaluated when determining the net operating income to compute a capitalization rate. The collected income from those leases has to be adjusted to what the probable income would be. Remember, the lease that offers the option to renew at a previously negotiated rate is a unilateral agreement (at the discretion of the lessee). If market rates are higher, the lessee will execute. If market rates are lower (as is the case in most instances), the lessee will not execute the option, but will re-negotiate to get the lower market rate.

Where does the economy go from here? For informed analysis and answers, please reference NetGain’s essay “America’s Current Economic Downturn and the Solution.”

Opportunity comes in many forms. Sometimes it’s the result of competent leadership. Sometimes it’s the result of leadership being beaten over the head so many times that they finally succumb and accept the inevitable. That appears to be the case for America’s next socioeconomic change. It was the theme NetGain chose for October: The next socioeconomic change and its impact on income property values.

Considering the enormity of publicity and the dire predictions promulgated by Secretary of the Treasury Paulson and Federal Reserve Chairman Bernanke, NetGain decided to put what it believes is the next socioeconomic change on hold until next month and examine our economy this month.

Why does NetGain care about the economy when its overarching interest is to provide information that minimizes the risk and increases the value of income property? Because whatever direction the economy takes, so goes the job market. And NetGain believes that “jobs” are the single most important driving force behind determining the value of income property.

Now, let’s back up, and get a better understanding of where we are as a country economically.

Where we are has been rehashed by the media and the politicians over and over. Simply stated and without pointing a finger at anyone, greed, leverage and poor oversight (what’s new?) has created the biggest threat to the American financial system since the great depression.
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