Archives for June 2015

The CAP Rate Controversy

The cap rate demystified…

When evaluating several properties to purchase, whether you’re investing in rental property or commercial real estate, experienced property investors use a cap rate formula to help crunch their numbers. Ultimately, the cap rate (more formally known as the capitalization rate) aids the investor in analyzing what property makes the best deal. It is used simply as an indicator – a directional arrow – as to which property SHOULD offer the best yields, and throw off the most profit for you in the future. However, a controversy has brewed of late about how much investors should rely on the cap rate.

What is a cap rate exactly?

A simple cap rate definition would be that the real estate cap rate is a calculation that measures the annual rate of return for any given investment property, or set of investment properties. The cap rate for any geographical area will differ, with the general axiom that the more in demand the area is, the greater the cap rate will be. These hotter markets tend to offer yields with cap rates around ten percent or more. However, low demand areas may throw off cap rates as low as four percent.

How to calculate cap rate

I have previously written about how to calculate the cap rate here. I have noted that the calculation for the CAP rate is easy; simply follow this order: ascertain the annual rent roll from a given investment property (making sure to double check and confirm any seller-given figures). If there are vacant property investor units in the building, you’ll need to ascribe a correct market rent for each unit. Make sure you check out several Realtor’s estimates, Craigslist listings, and have actually visited like units in other buildings to help determine accurate rent roll pro forma numbers. Then add up all the expenses associated with the building, on an annualized basis.

I had also mentioned that you should not forget a vacancy amount (usually between five to ten percent of total rent roll), as well as maintenance, taxes, insurance, electric, heating, and any other utilities the tenant will not be paying directly for. Of course, unless you’re paying all cash for the property, you’ll need to add in your mortgage payment on an annualized basis as well. Once you subtract the total expenses from the pro forma total income, you’ll have your (hopefully) positive cash flow number. This, of course, is your net income.

Cap rate calculation

Now simply divide the net income figure by the amount the seller is asking for the property. (As an example, if a property that throws off $50,000 in net income has an asking price of $500,000, then the CAP rate would be $50,000/$500,000, or 10%.) To reiterate, the greater in demand the area, the greater the CAP rate should be. In addition, you need to set minimum standards for yourself. Some investors won’t buy anything with a CAP rate below 5%. That’s up to you. But be sure to use the CAP rate to help you back into the highest amount you would offer for a property. The CAP rate can represent your rate of return on any given investment property.

At the beginning of your investment property search, a novice may initially want to use pen and paper, however, there are many real estate investment calculator programs readily available online to do the calculations for you. Simply plug in your specific numbers to software programs that act as a cap rate calculator…one of them is right here in the Tools section – and let them do all the numbers crunching for you…

Here’s the crux of the cap rate controversy…

Some real estate investment pros believe the cap rate to be too short-sighted…like looking at a landscape with a telescope. One such critic of cap rates is W. Grayson Powell, a broker and managing partner with Coldwell Banker Sun Coast Partners. In an article he wrote last year ( “Property Investment Cap Rates Aren’t Always Accurate, “ Wilmington Biz.com, September 1, 2014), Mr. Powell noted that “cap rates are solely based on property income performance for the current year. Cap rates don’t take into consideration factors that may affect property values five years or 10 years down the road. Because cap rates only deal with what a property is producing now, it’s a very shortsighted and narrow view of property value and should not be the number on which you ultimately base your purchase price.”

Like buying a used car?

He goes on to compare cap rate analysis with your decision-making process when buying a used car. He adds that “cap rates on income properties are often like the list price of a used car. They can be an indicator of the estimated value of the property and give you a starting point for your search, but there is more information and more work to be done before choosing a property and making an offer.” Mr. Powell then notes that “there are many factors to consider when determining and fine-tuning property valuations. Here are a few of them:

How good are the existing leases? A reputable grocery store with a 20-year lease is low risk; but a restaurant that’s empty most of the time with one year left on its lease is much riskier.
Is there a good tenant mix and do they effectively serve the needs and interests of the surrounding community? The demographics of a community can change, and the types of tenants must evolve to match the needs and demands of the people in the area.
What is the age and condition of the property? How soon will you have to pay for upgrades and repairs?
What is the current housing market and financial environment like? Are rental rates rising or falling?
What are the current interest rates and what are they expected to be in the coming months?
Are operating and management expenses rising or falling? Here’s a hint – they’re usually rising.
What are the historical occupancy, retention and vacancy rates for the property over the last 10 years to 15 years?
What are the tax implications of buying a particular property?”

Finally, he goes on to recommend “analyzing the cap rates and the values of each individual tenant, rather than looking at the property as a single entity. This provides a better picture of the actual risks that exist within a given property.”

The fallacy of his argument

My opinion is that, while all of his assertions are correct, he loses sight of the main reason why a property investor uses the cap rate: namely, to analyze what the investor should be offering to pay for any given investment property. Obviously, this will be highly subjective from investor to investor. However, keep in mind that, when a piece of investment real estate goes on the market for sale, the asking price of that investment property is pegged to a point in time. It’s not the asking price ten years from now. And the asking price usually bears some relationship to the prior year’s income performance of the property….and not to the performance in ten years.

And this is the main fallacy with Mr. Powell’s argument. I think it’s absolutely fair to consider a property’s short term performance utilizing the cap rate in so doing – because the cap rate will reflect the underlying value of the property today – when the asking price is set. After all, the asking price is not set some time down the road. As I mentioned earlier, you’ll be taking into account vacancy rates for the area when you figure your cap rate. And you’ll also be analyzing the future revenue potential of a property based on your expectations of what renovations will be needed to bring in current market rents, or how the rental market in general will perform down the road as well.

photos courtesy of hudsoncreg.com, joelane.com, denalipm.com, sanpedrosquareproperties.com, sultharproperties.com, usnews.com, mortgage.lovetoknow.com, whatsthepointofaventura.com

Are You The Real Estate Auctions Type?

The allure of the “steal”

Bidding at real estate auctions always attracts a certain segment of property investors. Whether it’s government auctions (gov auctions), foreclosure auctions or seized property auctions, certain types of investors are attracted to them. Call it the art of the steal…And there are a number of very large property auction companies that cater to, and aid in, the selling of distressed properties to investors. Some of the top auction houses include REDC (which is now known as Now Auction.com), Parrott Auctions.com, and Williams Auction.com.

Over time, I’ve developed a theory that auctions are alluring to two basic subsets of the real estate investor: the hardened, experienced pro, and the novice looking for the “steal” of a deal. It’s easy to spot the pro in the room – they’re the ones with the steely gaze, and the dispassionate air of someone who just doesn’t give a damn whether they acquire a property or not. They’re also the ones who have done their homework: they know exactly which properties they will be bidding on, what the market value of each property is now, and after they improve it, and have an exact “upset” price written down for each of those properties. That’s the price that over which, they simply stop bidding and let someone less experienced take their lumps on by overbidding and ultimately purchasing. They also are quite skilled at estimating their renovation costs.

The novice, on the other hand, is someone drawn by the extreme allure of making a steal of a deal. Usually, they have not done their homework, crunched the numbers, researched the area where the property sits, and think that, in absolute numbers, a low price equals a steal. Boy, they couldn’t be more wrong. And they traditionally last about, oh, one auction. Then they get burned financially, and leave the next auction for the pros – and for more novices to take their place.

An instructive tale of woe

For an illustration of the large downsides of auction buying for the novice, let me provide a highly entertaining example of a recent exchange I had with such a novice auction investor. As a real estate broker, I had gotten a call from a novice buyer who had purchased a small three bedroom single family house at auction a year earlier. He had done nothing with it – yet – and wanted to, as he put it, “unload it quickly.” And he wanted my estimate of its current market value.

Since he lived hundreds of miles away from the property, I asked him for a key to gain access. He said he did not have one. I asked if his tenant had it. He said he did not have a tenant. Upon further questioning, I figured out that he was not being very forthcoming (I assume out of sheer sheepishness for buying this turkey of a property), and that he had never even seen the property in person. Yikes. I was dealing with a definite novice auction buyer. One who had not done any research whatsoever as to the market, current condition of the property, or what the value would be if he improved it. I performed my normal regimen of research, and saw that he had purchased the property at auction for the very modest sum of $2,100. I’m sure he thought he could make a killing on it. Ugh…

Will the fun ever end?

I went over to the house, which was situated on a small, but secluded lot, far away from the center of town in which it was located. I was able to make it through the first line of overgrown grasses and shrubs to the front porch. As I peered in, I saw the place was utterly trashed as, alas, many foreclosures and county-owned properties can be. Prior owners just feel the need to “get back” at the big bad lender who held their mortgage, and who forced them out. It’s a simple reality in the property investing business, and we tend to get inured to the sight. But in addition to the house being in such a sorry state, it also had a tremendous amount of wood rot visible to the naked eye, and I felt unsafe even being on the front porch. In a way, I was glad he hadn’t sent me a key. (Yes, the front door was locked.)

Costly mistakes…

I quickly saw that the property in its current condition would have to be sold for its land value only. Unfortunately, that would not be much more than what the novice paid for the property. Further, I told him I did not want to represent him (liability problems galore there – especially if a potential buyer falls through the floor), and of course, there was little money to be made in the simple brokering of any deal. To make matters worse, I felt the renovation costs to bring the house up to rentable, or market value for-sale condition, would far outstrip the amount he could get for the property when he sold it. My recommendation: best to get out now, list it on Craigslist, and try to get out for close to what you paid for it. He of course has already been paying carrying costs like taxes and insurance on it for over a year already.

Are real estate auctions investing for you?

This little tale of woe should be heeded by any property investor considering jumping in as a novice to the property auction bidding process. If at all possible, and if it interests you and you have the right temperament, go in and watch the pros, and how they conduct themselves at auction. Ask them how they do it – every experienced auction property investor has their own unique “system.” Learn from them before diving headfirst into the auction waters. You’ll save yourself the grief of someday calling a Realtor saying you’ve got this piece of property you bought, sight unseen, that you need to unload…quickly.

photos courtesy of roarlocal.com, giyum.com, mcginnisauctions.com, houstonauctioncompany.com, howtobuyusarealestate.com, realtor.org

Is Airbnb Smart For Property Investors?

The vacation rental conundrum

In general, vacation rentals have been a secondary and riskier source of property investments for the experienced investor. They represent a greater degree of risk than year-round rental units simply because they tend to be seasonal in nature. So cash flows thrown off from any vacation rental property are not uniformly consistent throughout the year. Ultimately, this makes for a greater likelihood of negative cash flows on an annualized basis. In addition, vacation homes, and time shares as well, are difficult to predict performance over the long term, due to market fluctuations and the overall state of the economy – depending on where they are located. Certainly foreign investments are even riskier, having much greater market fluctuations abroad than in the United States. Values can drop unexpectedly based on demand factor fluctuations. After all, vacations are made up of leisure time dollars. Thus, trying to predict future rental income and cash flows based on prior historical data is a tricky proposition. Also, keep in mind that vacation homes and time shares can be difficult to sell quickly should you need to get out fast.

And then came Airbnb…

With the creation of Airbnb in 2009, however, small investors have been able to utilize their own homes as investment property, converting them into part-time hotel lodgings, available to the entire world. Now you don’t have to have a villa overlooking a beach front property to get in on the action. Your small studio apartment in an active metropolitan area can suffice as a money-maker. So what is Airbnb? It’s simply an online booking service that anyone in the world can partake in – either as a host, offering your home or unit for short-term lodging, just like a hotel does. Or, you can be a traveler who actually books a lodging in one of Airbnb’s host sites. And you would book a reservation much like you would for any hotel room. This privately held company has grown exponentially since it began, and now has a twenty billion dollar valuation, and may be going public soon as well.

Airbnb offers the ability to search for lodgings of its hosts’ units by location. For example, host lodgings are quite plentiful in large metro areas. Airbnb NYC is the obvious choice for those travelers looking to book vacation accommodations in New York City. And Airbnb has numerous other search locations as well, world-wide. And they earn their revenue by charging a fee for every transaction, be it for hosts or travelers (though travelers pay a higher fee).

Airbnb reviews

This business model may seem like an excellent source of additional income for the small property investor. However, keep in mind that Airbnb has been getting a great deal of flak over the last couple of years. It seems to be in a constant battle with the hotel industry (naturally). And many recent bad reviews come from a number of horror stories associated with the service. In an online article by George Hobica ( “10 Incredible Airbnb Horror Stories,” FoxNews.com, May 8, 2014), Mr. Hobica lays out many tales of woe associated with the service. As an investor, you should be certainly wary of these reports. He notes that “in many cities, Airbnb is flat out illegal. You can actually be evicted during your stay – it’s happened – and your host could find themselves on the street, right along with you (this has also happened).” He goes on to say that “I also know of users who have booked – and paid for – apartments listed as completely private, only to find them anything but. I’ve heard of hosts informing guests halfway through their stay that they’re moving the guest across town, with no compensation for the hassle. As is to be expected when you book into a stranger’s home (or, when you rent your home out to strangers), things can get plain weird.”

Some cautionary tales

Mr. Hobica summarizes in his article ten different horrendous scenarios. Here are some of the most egregious ones he reports: “The meth addicts…Troy Dayton rented out his home in Oakland, Calif. to a young woman who turned out to be a meth addict and who trashed his home and stole his birth certificate. A request to Airbnb to have his birth certificate replaced and the damages covered was ignored; he was eventually begrudgingly given some site credit. The sudden eviction…Matt Lynley moved to New York ready to take over the world – but first, he’d come face to face with some of Airbnb’s greatest weaknesses. He reportedly wound up having his reservation cancelled when an owner wouldn’t verify a booking (that’s part of Airbnb’s system), and as a result had most of his cash tied up in the pending room charge. Lynley ended up finding another place, but was out the money until Airbnb refunded it. The fraudulent rental…A California man was enjoying his rental in Berlin when a knock came at the door from a man who professed to be the real owner of the unit, wondering what was going on in the apartment. “This guy with a thick Russian accent knocks on my door, demanding what I’m doing in his house. For a moment I thought I was in a bad 80s movie,” he said at the time. The pop-up brothel…Two Stockholm women handed over the keys to their apartment only to find eventually that their flat was being used as a brothel. How’d they find out? The police alerted them that their home had just been raided – two working girls had been caught in the act.”

The problems keep multiplying

Much like driver services like Uber and Lyft Driver, Airbnb has been experiencing many legal problems despite its enormous growth. For this specific reason, property investors should be most concerned with getting involved with the service. For example, in New York City, short term lodgings are highly regulated. A permanent resident of a lodging facility must be present when subletting an apartment for fewer than 30 days. Obviously, this law is designed to protect the extensive hotel business in the city. But Airbnb hosts have run afoul of this particular law on many occasions. In a recent newspaper article by Lisa Fickenscher ( “Airbnb Feeling Effects of Big Apple’s Illegal Rent Crackdown,” The New York Post, June 5, 2015), the reporter notes that “New York’s crackdown on illegal Airbnb rentals is starting to hit home for the controversial Web site, a new analysis shows. Airbnb’s growth had been surging in the Big Apple — but that was before this year when the city put more muscle into purging bad actor landlords that violate short-term rental laws. There were 15,485 illegal listings in New York — out of more than 27,000 — as of May 1, down 3 percent from January, according to insideairbnb.com, an independent Web site that tracks the San Francisco-based company’s listings. The decline is significant because Airbnb’s growth has seemed unstoppable since it launched here in 2009.” Ms. Fickenscher goes on to quote a local politician: “Increased attention to and growing outrage over Airbnb has compelled the city to increase its enforcement against illegal hotel activity,” said Assemblywoman Linda Rosenthal, D-Manhattan. “It’s clear that this has had a chilling effect on the industry.” The crackdown could slow Airbnb’s growth in New York — and potentially other big cities that see the online room-rental company as a threat to affordable housing and the hotel industry.”

The takeaway

I’ve written in several articles here that vacation rentals are inherently riskier investments than year-round rentals. With the advent of Airbnb, and its tremendous success and popularity, property investors should take note of the pitfalls of this type of investment when considering all their investment opportunities in real estate. Certainly, know your local laws regarding short term rentals. And also be wary of one other story that has circulated in the news recently, providing Airbnb with some rather nasty bad publicity. The incident involved a host who rented out their unit to a traveler for a month, only to find that the traveler would not leave. Due to local law, once the traveler occupied the unit for at least 30 days, they were considered a “tenant.” And as such, they were afforded all protections due tenants in tenant law. And the host had to go through a very long, expensive eviction procedure to have the “traveler” removed. Again, property investors need to be very wary of all local ordinances regarding short term stays, as well as landlord/tenant law before using a service such as Airbnb.

photos courtesy of trexglobal.com, nypost.com, huffingtonpost.com, wired.com, nymag.com, fastcompany.com

Look Out For These Property Investor Risks

Property risk definition

Any novice property investor is prone to make rookie mistakes when investing in property– and being unaware of the basic pitfalls that investment property can present is chief among them. After all, investing in real estate is a time consuming, largely capital-intensive way of making money. In addition, even if you are choosing to own shares in real estate funds like Real Estate Investment Trusts (REITs), the basic underlying problems remain. Here are some of the key risks involved in any real estate investment – be they investing in houses, commercial real estate, foreign investments or time shares for that matter.

Some sage property investment advice

Novice investors should be wary of any real estate project that involves negative cash flows. Second homes and land speculation are prime examples, however even simple “fixer-uppers” can become disastrous for throwing off large sums of negative cash flow (also known as “negative gearing”). Unless you’ve had experience with land development, steer clear of this form of property investment. In general, be as conservative as possible when numbers crunching for fixer-uppers. Obtain several contractor estimates for the scope of work to be done prior to even making an offer on a rehab project. Without a doubt, investing in negative cash flow real estate should be attempted only by those with deep pockets, looking to shelter other forms of income from the tax man. The losses thrown off by negative cash flows will aid in reducing the bite of their overall tax bill. So, in effect, negative gearing makes sense for them…but not so for the novice investor actively looking for profits from the outset.

What is investment property?

Investment property is any real estate designed to earn a profit for the investor. And this means it can be located anywhere in the world. However, if you’re considering foreign property investment, think again. The novice property investor should be aware that buying foreign real estate is fraught with inherent risks. (Are you an expert in the politics of the country involved? Are they stable? How many trips abroad are you considering making to watch over your property? And what are the costs involved with those trips? Who do you call when a problem arises with the property in an emergency? Other major risks that can be found in in foreign real estate buys include fluctuating currencies, different real estate laws by country, as well as the singular lack of real estate protections afforded property here in the U.S. compared with other countries. These are all concerns – and inherent risks – only the well-experienced should address. In addition, I have always advocated buying close to home. You know your home area better than any other, and you won’t be considered an absentee owner. Too many tenants like to take advantage of the property and its landlord when they know the owner lives far away…

Owning property – sort of…the risks of time shares

Another important risky real estate area are time shares. They represent some of the highest levels of property investment risk. Time shares are very risky because it’s difficult to predict what, if any, value will accrue over time, the longer you hold onto them. They are very sensitive to market fluctuations, and can drop in value quite suddenly as well. In addition, time shares are very hard to predict with any degree of certainty their future positive cash flows based on prior years performance levels. Finally, these time shares can be difficult to sell when you need to, which can create an ugly financial situation for you when you are most exposed.

photos courtesy of kristinandcory.com, wilmothpropertyservices.com, sellworldmarktimeshares.com, foreclosure-support.com