Is it time for “cap rate” calculations for single family homes?
By Vena Jones-Cox

There’s a big divide in the thinking between commercial and residential real estate investors.
In commercial real estate, purchases are made (which is to say that prices are set) based upon the capitalization rate, or “cap rate”.
The cap rate is a number that’s derived from 2 numbers: the net operating income—that is, the gross scheduled rents less all the real expenses of running the building except debt service and income taxes; and the acquisition costs, which include the purchase price, any immediate repairs, and any miscellaneous purchase expenses.
So a property that has a net annual operating income of $50,000 and costs $1 million to buy and renovate was purchased at a “5 cap”, or 5% cap rate.
Higher-risk properties in higher-management areas are expected to have a higher cap rate;
People who buy single family homes for income, on the other hand, value properties based on the after-repaired value and cash flow. So in making a buying decision, they look at math like this:
After-repaired value of the property: $50,000
Purchase & rehab costs $35,000
Equity $15,000—30% of ARV
Rent: $750
Taxes: $55
Insurance: $35
Maintenance & vacancy $150
Debt service $270 (8% loan for full purchase & rehab cost, 30 year am)
Cash flow $240/mo

30% equity + $240/mo cash flow is deemed to be “enough”, and the deal is consummated.

There are 2 basic ways in which our residential evaluation is inferior to a typical commercial evaluation.

The first is that ARV—after-repaired value—is often difficult to determine in rental neighborhoods in today’s market. If you’ve ever struggled to find a sale of a similar property that WASN’T a sheriff’s sale, bank-owned property, short sale, or “handyman’s special”, you know what I mean.

In commercial real estate, the value of a property is based on its income, which, when you think about it, should also be the way we evaluate single family rentals. If the highest and best use of the property is as a rental, rather than as a home owner property, then what it’s worth to the best BUYER—a landlord looking for return—should be based on what that return will be, rather than on its resale value.

The second advantage to the “cap rate” method of determining value is that the cap rate can be adjusted to take into account real or perceived risk associated with a particular property.

For instance, a commercial investor evaluating a type “A” property (a newer property with all the amenities of new construction) in a type “A” area (high income, low vacancy) might accept a 5-cap—that is, a 5% rate of return—on such a property, under the theory that it will be easy to maintain, easy to manage, easy to fill, easy to collect rents, and so on.

On the other hand, the same investor evaluating a type “C” property (older, functionally obsolescent, needing major updating) in a class “B” area (middle-ish income, older area) might not accept an overall cap rate of less than 7-9%, due to the greater investment of time and money into the needed rehab, the higher management hassles, and the overall greater risk.

When we invest in single family homes, we don’t necessarily evaluate and take into account “risk” in such a dispassionate, logical way. Instead, we make decisions based on numbers that don’t always matter that much. Who cares what the ARV of a rental property is, if we’re not going to resell it anyway? Would you overpay for a $10,000 house if, at your purchase price, it cash flowed $1,000 a month? Would you think that buying a rental for 25% of its ARV was a good deal if it had negative cash flow of $100 a month at that price? Is a property that you’d pay $35,000 for in perfect shape still worth $35,000 if the purchase price is $3,000 but it needs $32,000 in foundation work?

Perhaps it’s time for a shift in our thinking—one that asks the question, “What return would I want on this property if it were MY cash that I was investing in it?” And this means applying a cap rate analysis to single family homes.

Now let me reveal something about commercial cap rates that won’t apply to my proposed residential cap rate. The commercial investing world is much more organized, transparent, and professionalized than the small residential real estate world. As a result, if you’re a buyer looking for, say, a 12-20 unit building in the zip code 45219, you can literally Google the expected cap rate for that property type in that area (it’s 6-7%, in case you’re wondering). How is this possible? Because commercial agents and organizations like Apartment Associations, Universities, the Building Owners and Managers Association, and dozens of others carefully keep track of what’s on the market, what’s selling, for how much, and what the resulting cap rate is.

The ease of getting this sort of information about commercial properties allows buyers to have a reasonable starting point from which to begin an offer calculation. The fact that a 7 cap is on the high end of cap rates in 45219 doesn’t mean that a buyer will make an offer that represents a 7 cap; if the property is 100% vacant and needs complete lead remediation, he’ll want a higher cap rate to compensate for the increased hassle and holding time.

We don’t have access to this kind of data for single family homes for two reasons: first, our colleagues don’t think in terms of cap rates, and thus can’t report the cap rate at which they bought any particular property; second, even if residential buyers could do such a thing, to whom would they report it? There are no organizations in small residential real estate that collect and distribute data like this.

So where should we start to determine acceptable cap rates for a given property in a given area? My suggestion would be that we begin with the folks who actually ARE buying these properties strictly on the basis of return: turn key rental buyers.

Now, if you’re a long-term inner circle member, you’ve heard my rants about how turnkey rental returns are rarely the same as what’s published, because the way in which they’re derived often leave out or underestimate important expenses like, say, vacancy and reserves. But for our purposes, it’s really not important what returns turnkey rental buyers ARE getting, but rather, what they THINK they’re getting. And the number that seems to attract yield-driven, non-real estate professional buyers to rental properties in rental areas is around 10-12% unleveraged cash-on-cash return—in other words, cap rate.

So, for instance, a property with the following characteristics:

Rent: $750
Taxes: $55
Insurance: $35
Maintenance & vacancy $150
Net operating income $510/mo

(note: debt service is not accounted for in a net operating income calculation, as individual investors have different financing strategies with different loan to value ratios, rates, terms, and so on. In order to calculate a true capitalization rate, these differences must be taken out of the calculation)

Has an annual cash flow of $6,120. The value at a 12 cap—in other words, the value to a turnkey investor, if the property were fixed up and operating—would be $6,120/.12, or $51,000. Thanks to the simple application of a cap rate to the net operating income of this property, we now have a workable “ARV” of a property, even if there are no fixed-up comps in the area that have sold.

Let’s further assume that this property is not in fact fixed up or rented, and that the cost to renovate and hold the property will be $7,000. According to our usual calculation, this would mean that we’d want to pay, at maximum:

$51,000
X .7
$35,700
-$7,000 repair costs
$28,700 purchase price

Since our total investment would be $35,700, we’d actually be buying this property at a 17 cap ($6,120/$35,700), which makes sense based on the fact that we’re taking on additional hassle and risk of the rehab and holding time.

But what if the ARV were the same, but the repair costs (and therefore entanglement and risk) were much higher—say, $20,000? Our NORMAL calculation would then be:

$51,000
X .7
$35,700
-$20,000 repair costs
$15,700 purchase price

However—and this is important—if you paid $15,700 for this property and put $20,000 in repairs into it, you’d have the same $35,700 in the property and would get the exact same unleveraged cash on cash return as the guy who bought the $28,700 and only spent 2 weeks and $7,000 repairing it. And that’s just crazy.

Let’s look at the same property from a cap rate perspective, and make a decision that we’d want at least a 25% return on this deal, because of the complications. In this case, we’d decide what to pay based on this calculation:

$6,120 net operating income/.25 cap=$24,480 total purchase and repair cost - $20,000 repair costs =$4,480 purchase price.

Yes, I know—cap rate calculations don’t take into account any equity you’re capturing, or any longer-term appreciation that the property might generate. And yes, a 12 cap may not be reasonable or achievable in a starter-home rental as opposed to a rental-area rental (but higher appreciation and higher raw-dollar equity from a below-market purchase offset this). And yes, the decision to accept a 25% cap rate vs. a 14% cap rate on a fixer is still a personal one.

But if we all began looking at OUR rentals from the logical, mathematical perspective that commercial investors use to look at theirs, we’d make better buying decisions and have an easier time evaluating properties to begin with.

Reprinted with permission of Vena Jones-Cox. To get more free articles and tips, subscribe at www.TheRealEstateGoddess.com