All investments have their breaking point. It happens when the risks become greater than the rewards. Some investors believe that will never happen for income property. Those people usually think that way because they (1) are not investing their own money, and/or (2) don’t understand that income property is cyclical. This type of thinking usually indicates a failure to understand the mathematics of investment recovery. The law of mathematics dictates that whatever percentage an investment declines, it must increase by a geometrically higher percentage to achieve parity.

Finding the breaking point where the risks of buying property are greater than the rewards has become an important issue. When you add Wall Street’s recent large capital infusions into privately and publicly held property to the enormous number of 1031 exchange transactions by individual investors, you have investors under pressure to buy property. The result is that a sense of urgency has emerged.

Why the concern? This urge to buy has increased the price of income property while driving down its capitalization rates (cap rates). The number of income property purchases being made at 5% cap rates is on the rise. Buyers of income property who earlier vowed never to buy real estate below a 7% cap rate are now trying to hold the line at 5%. Consequently, recent cap rates have forced investors to ask the question: When currently buying income property, is 5% a safe cap rate? The answer to that question, when one looks at the numbers unemotionally, is a resounding no!

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

Economic truth number one (strong market) covers the mistake of buying real estate at a 5% cap rate. Economic truth number two (weak market) aggravates the problems of buying real estate at a 5% cap rate. Economic truth number two is the reason that 5% is not a safe cap rate.

The following assumptions illustrate the financial problems of a 5% cap rate during a weak market (economic truth number two).

• Purchase price: $1,000,000
• Economic occupancy on purchase: 95%
• Cap rate: 5%
• Down payment: 50%
• Mortgage: 30 year amortization, interest rate 5%
• Operating Expenses: 40% of first year’s income
• Economic vacancy: declines each year by 5%

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