Define: Cap Rate (real estate for profit)

While I was still researching homes, I was checking out a real estate blog that apparently Donald Trump recommends. In it, it linked to an article titled "Cap Rate Catastrophe" which had me curious...

So capitalization (cap) rate according to wikipedia is a %: the net income / cost. For example, if you had a 1 mil home and had 100k income per year, that rate is 100k/1mil = 10%.

Ok, so at 10% you make your money back in 1/.10 = 10 years. At 5%: 1/.05 = 20 years. 4%: 25 years. 1%, 100 years. But then you still have the property, you could say invest, make 1% over the year, and sell the property - any income is good, right? Wrong:

Capitalization rates in the range of 3.5% to 5% are less than the rate lenders currently charge for mortgages on income properties. One of the crucial investment rules that applies to income property is to never invest with a negative spread, a cash-on-cash return lower than the mortgage rate. Why is this rule so important? Every penny borrowed on an income property with a negative spread is a guaranteed loss. Simply stated, if the capitalization rate is 3.5% and the rate to borrow is 5%, every $100 borrowed results in a $1.50 annual loss.

Ok, so that's if you have no money - then that makes sense. You borrow a $1mil @ 5% interest and only make 3.5% a year, that's clearly a net loss. What if you have the money though? Quite frankly the mortgage rates seem like a good rule of thumb for how much you *should* be making on an investment. If I had $1mil and invested it for the year and only got 3.5% back when I could have been getting 1.5% MORE - that's considered a loss too.

So you get 3.5%, that's still ok, right? You don't want to be greedy - you can still sell the house at the end for roughly the same price and keep your 3.5% - that's good, right? Wrong:

Cash-on-cash returns for income properties with a negative spread are not as attractive when compared to income properties with positive spreads. Consequently, income properties with a negative spread attract less capital. Less capital translates into market value atrophy.

So your $1mil investment you thought was good at the time? Well when you try to sell it, a buyer will see the negative spread and not be interested. In fact, if the cap rate was only 3.5% and the expected rate should be 5%, 3.5/5 = 70%. So your $1mil investment should only be worth about $700k in the market when you try to sell it again. $300k loss over the year - bad investment.

So these rules kind of help you predict if you really are getting a good deal. For a $500k house, consider if you can make 5% on the property. That's $25k/year, ~$2k/mo - AFTER yearly maintenance expenses. If you can't, then it's probably a bad deal...

Read: Article, Wikipedia: Capitalization Rate