Cap Rates & 50 Million Dollar Bills — What WOULD I Do?

Posted @ 10:07 am - Filed under Cool Info

My post on cap rates this past week generated a thoughtful comment from Christ Smith, the post’s inspiration. He also wondered if readers might think he was paying me a fee to mention him.

Chris — You’re worth a fee.

Having 50 million dollar bills would change everything. I’d be a total hypocrite and buy all the super located NNN leased properties with high cap rates I could get. I’d also acquire a few 5-star mobile home parks, and/or some well located mine-warehouse storage operations. Then I’d make sure all the checks were wired to the correct bank account — which would be my management time each month.

Of course I wouldn’t really be a hypocrite, cuz that’s what I’d do for anyone with that kinda scratch. They’d want quality no-hassle cash flow.

Your comment helps me make my point more easily.

Search my archives for ‘get outa dodge’ and you’ll quickly see I wouldn’t buy anything anywhere near L.A. — regardless of the cap rate.

A block of duplexes in East L.A. is what I’d avoid like the plague. Remember, I’m going for capital growth, not cash flow. East L.A. cap rates are of course higher compared to Beverly Hills cuz most folks live in the relatively low rental rate areas cuz they have to, and in areas with mansions cuz they wish to.

I’d buy a block of duplexes in a growth region which allows for leverage, fixed rate debt service, quality tenants, and a break even or better from Day 1.

We don’t ‘expect’ higher appreciation, we research, apply our expertise, and make a prudent judgment call. Let’s take a growth area in Texas and compare it to your block of stuff in East L.A.

Again the point: In residential income property, cap rates, at least for the relatively smaller units (1-4) are not all that crucial. The rent/price ratio is probably far more critical. And yeah, I realize that contributes to the cap rate, so don’t have a coronary. Still, the lower the tenant quality, the higher the management costs. Much of what you think you’re gaining in cash flow you’re giving back in increased operating costs. Those insisting on diving into high cap rates and cash flow when their agenda is primarily capital growth, soon realize how cold the water real is. I’ve been there, and it’s no fun. Turns out one of the unintended consequences of chasing high cap rates and cash flow is dealing with higher operating costs, and lower appreciation rates. And a brisk reality check!

Isn’t that backwards? Yep — so stop it. It makes no sense in real life to buy properties in obviously inferior locations so you can point to high cap rates and marginally increased rent/price ratios. In the end, most of the so called high cap rates turn out in hindsight to have been mythical when the rubber hit the road anyway.

Remember — the idea is to grow your capital. A few thousand bucks over a 5 year hold period is just not worth receiving $50,000 less in appreciation. Is there anyone not in agreement with that?

Think about location for a minute. Do you live where you want to live, or where you have to live? If the deciding factor was financial, and you’re living where you want to live, where did you avoid?

In San Diego we have a perfectly good area in the East County, an incorporated city called El Cajon. Roughly half of the population rent. The rent is far lower for comparable property than the contiguous city of La Mesa. La Mesa is a popular place to live, and has been for as long as I’ve lived in San Diego — 1967. El Cajon on the other hand, at least for renters, is the option of choice only because their rents are far lower than can be found in La Mesa.

Guess which city has higher quality tenants, lower cap rates, better appreciation, and higher tenant and investor demand? Duh. We’ll consider that question rhetorical.

The lesson here is simple: What’s in text books and what you find in real life aren’t the same. (Stop, I wanna write that gem down.) High cap rates in a book are cool. Yes, I’d rather have the property in ‘Chapter 5′ of How To Be a Successful Real Estate Investor’, no doubt.

Here’s the dirty little secret.

They don’t exist and haven’t since I was born. They simply aren’t worth the trouble. And in the end, the appreciation is terrible when compared to the so called inferior cap rates elsewhere.

In fact, I’ll buy a bunch of East L.A. duplexes and trade them for a small loss for some of your brand new Texas duplexes — and I’ll give you a small profit to boot. And in five years I’ll be so far ahead in any way you wanna measure I won’t be able to see you in my rearview mirror.

Chris and I agree that high cap rates on preferred to low. That said, only when they’re taken in the context of superior locations to begin with does it become a real life decision.

This must be one of those areas in which he and I differ by ‘degree’. We’ve always gone our separate ways on this issue. Still, I’ll bet given the choice, he buys Texas duplexes before he buys East L.A.

This entry was posted on Monday, January 28th, 2008 at 10:07 am and is filed under Cool Info. 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.