Is 5% a Safe Cap Rate?

19 Feb

Results of Assumptions

Economic Vacancy	5%	20%
Cap Rate	7%	7%
Property Value	$1,000,000	$750,000
Property Income	$116,666	$99,166
Property Operating Expenses (40%)	($46,666)	($46,666)
Net Operating Income	$70,000	$52,500
Debt Service	($32,208)	($32,208)
Cash Flow	$37,792	$20,292
Return on Purchase Price (%)	0%	(25%)
Current Yield On Down Payment (%)	7.6%	4.1%
ROI (PP-PV+CF) (Cash)	$37,792	($229,708)
ROI (PP-PV+CF÷DP) (%)	7.6%	(46%)

Summary of Results

The difference between buying real estate at a 5% cap rate and a 7% cap rate is not in the decline of investment value. Using the same economic occupancy and the same leverage results in an equal investment change.

The difference between the two cap rates is in the cash flow and cash yield. The 7% cap rate funds the reserve account and pays the investor a positive yield. The 5% cap rate does not fund the reserve account and does not have funds to pay the investor a yield. This means that the 5% cap rate does not have enough cash available to maintain the property as planned and compete against properties purchased at a 7% cap rate. The conclusion: For real estate buyers, currently a 5% cap rate is the breaking point when risks become greater than rewards.

Another way of saying the risks are greater than the rewards is that the investment lacks staying power. How important is staying power? Consider our two earlier facts. (1) Real estate is cyclical, and (2) whatever percentage an investment declines, it must increase by a higher percentage to achieve parity. Given those two factors, staying power (a 7% cap rate) becomes the real estate buyer’s insurance policy for achieving investment success.

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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.