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!

Two economic truths decide the investment result of real estate purchases: (1) When the supply of real estate is more than the demand (weak market), rents stay the same or go down, vacancies go up, and concessions increase. (2) When the demand for real estate is greater than the supply (strong market), rents go up, vacancies go down, and concessions decline or disappear.

Economic truth number one (weak market) exasperates the problems of buying real estate at a 5% cap rate. Economic truth number two (strong market) temporarily disguises the mistake of buying real estate at a 5% cap rate.

Assumptions

• Purchase price: $1,000,000
• Economic occupancy on purchase: 95%
• Cap rate: 5%
• Down payment: 35% ($350,000)
• Mortgage: 30-year amortization, fixed interest rate at 6% + normal closing costs
• Operating Expenses: 40% of first year’s income
• Economic vacancy: declines each year by 5%

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