Is 5% a Safe Cap Rate?

19 Feb

Results of Assumptions

Economic Vacancy	5%	10%	15%	20%
Cap Rate	5%	5%	5%	5%
Property Value	$1,000,000	$916,660	$837,500	$762,300
Property Income	$83,333	$79,166	$75,208	$71,448
Property Operating Expenses (40%)	($33,333)	($33,333)	($33,333)	($33,333)
Net Operating Income	$50,000	$45,833	$41,875	$38,115
Debt Service	($32,208)	($32,208)	($32,208)	($32,208)
Cash Flow	$17,792	$13,625	$9,667	$5,907
Return on Purchase Price (%)	0%	(8.3%)	(16.3%)	(24%)
Current Yield On Down Payment (%)	3.6%	2.7%	2%	1%
ROI (PP-PV+CF) (Cash)	$17,792	($69,715)	($152,833)	($231,793)
ROI (PP-PV+CF÷DP) (%)	3.6%	(14%)	(31%)	(46%)

Summary of Results

Let’s look at the results of a real estate purchase at a 5% cap rate when economic occupancy moves from 95% to 80%. Is 80% economic occupancy unrealistic? It’s as unrealistic as 88.33% physical occupancy plus a one-month rent concession. Put in those terms, 80% economic occupancy becomes and is very realistic. Additionally, 50% leverage is conservative and there is no allowance for reserves which in this case would be $20,000 (usually 2% of the purchase price). Finally, when economic vacancy increases, operating expenses don’t remain the same, they increase. Now let’s look at the numbers.

When the economic occupancy declined from 5% to 20%, the cash investment declined 46%.
The investment losses do not consider the costs of a sale.
The investment losses do not consider the financial terms (income guarantees, warranties, seller financing, etc.) the next buyer would probably negotiate.
The property is not generating enough to fund reserves.

What would have happened if our real estate investor bought the property at a 7% cap rate? Using the same assumptions from the prior example, here’s what happens with a real estate purchase at a 7% cap rate when economic occupancy declines from 95% to 80%.

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This entry was posted on Monday, February 19th, 2007 at 12:29 pm and is filed under Articles, Risk Reduction. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.