What is the importance of cap rates? Too many real estate investors give the cap rate a crown it sometimes doesn’t deserve.

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Transcript:   Cap rates is the rage. It’s always been the rage. It goes up and down in popularity, but so often people get lost in the forest with it. Here’s the deal. First of all, check out the quality of the location. The cap rate is going to go down in relationship to the higher quality locations. There’s a reason for that. You have to pay more for the property, there’s more demand for better located properties than poor located properties. That’s no news. Here’s the problem. When you go to the poorer neighborhoods because you get better deals and you get higher cash flow and that higher cash flow is a result of maybe double digit cap rates, you might have a ten, eleven, twelve, I’ve seen people brag about fifteen percent caps and higher. The problem is your expenses are going to be higher because the quality of tenant is lower. You’re going to have higher maintenance because typically in those neighborhoods the properties are older, not newer. They’re not young properties. Many times they’re built not quite as well as in the better neighborhoods. That’s not universal, but I’ve seen it too many times in many big cities. People get … They fall prey to the allure of the romance of high cash flow, and here’s what happens, they find out that that twelve percent cap rate really turned out to be a whole bunch of nine because when they look at what the real expenses are, they look at what the real vacancy rates are, and it’s not just vacancy rates themselves, it’s how long it actually takes them to find a good client … tenant rather, and then that tenant is late and they don’t get the income. It goes on and on. The turnover is higher. That makes the vacancy cost higher. You’re cleaning up more times. You’re spending more money. All that lowers the cap rate. You might think you bought twelve percent but what you’re living is nine percent. Meanwhile, back at the seven percent cap rate property that your friend bought three miles away, his property was anywhere from new to ten years old, it’s in a very well-established neighborhood that has exhibited high demand for a decade maybe, maybe more. The neighborhood schools are well thought of. It’s got all the retail outlets you want. It’s close to this mall or that mall. It’s got the grocery store. In other words, all the things you grew up with that you like in your good neighborhood as a kid. Now what happens is instead of living there for six or twelve months many of your tenants will live there for one, two, or three years, maybe more. You’re not having all those expenses. Plus, they tend to treat the property better. When you go to sell a lower cap rate property in a much higher quality neighborhood, for every buyer you have for that high cap neighborhood you’ve got ten for yours because investors who know what they’re doing would much rather have the higher quality tenants, the lower vacancy rates, the lower operating expenses. When they buy a cap rate that is much lower than the twelve you thought you were getting, in real life that’s exactly what they got. That’s why you want to pay attention to real cap rates in better located neighborhoods.