Capitalization rate: How to use cap rate in your real estate investing

The good folks over at Property Metrics wrote this very helpful blog post about capitalization rates in real estate investing. The post explains what cap rate is, how to calculate it, when investors should use it, as well as some alternatives that some investors use.

In my opinion, cap rate is one of the key metrics that real estate investors need to know about their properties — current properties as well as potential deals. Investors should memorize the simple calculation to determine cap rate so they can calculate it quickly (annual net operating income/cost of deal)

Admittedly, cap rate is a back-of-the-napkin type of of calculation and there are other factors that have the potential to impact the cap rate (such as a regular increase in annual net operating income or growing costs to maintain the property, etc.) But overall, this is a very servicable calculation.

There are three reasons why I really like the cap rate.

CAP RATES EXPRESS THE OPPORTUNITY (OR COST) OF RISK

I’ve been writing a lot about risk and risk management lately as I interact with Aswatch Damodaran’s excellent book Strategic Risk Taking. Cap rate fits right into the conversation of risk management because cap rates help you quantify the reward you get for the risk you take in real estate investing.

Many potential real estate investors scratch their head in wonder at how to determine whether or not a deal is worth doing. The cap rate, in spite of its flaws, helps to illuminate the answer. Investors can compare the cap rate of the real estate deal against the returns they can expect to get from other investments. In the article by Property Metrics, they give the example of someone who has $10 million to invest and they can invest their money in a property with a 5% cap rate or a 3 month T-Bill with a 3% yield (and is often called “the risk-free rate”). The difference between the two is 2%. That’s the return you get for the additional risk you’re taking over and above a T-Bill.

It doesn’t matter how much money you have to invest, the comparison is the same: Look at the amount of money you have to invest and compare your real estate investment options it to a T-Bill. The difference is the return percentage you hope to earn for the additional risk you’re taking on.

CAP RATES ENABLE YOU TO COMPARE ALL DEALS

When you are trying to decide if a deal is worth doing, or if you are trying to choose one deal from several potential deals, the cap rate can help you here as well. Cap rates reduce all of your deals down to one easy-to-compare number. So if you are looking at a commercial property or a bungalow or an apartment complex (which are 3 very different real estate investments), you can still easily compare them. Obviously this isn’t the only piece of information you’ll use to determine whether or not you want to do a deal but it’s a helpful piece of information.

CAP RATES HELP TO KEEP YOU ON TRACK

As the article indicates, cap rates viewed over a period of time can reveal trends. When you view cap rates for a particular market, you gain a glimpse of how that market is doing. When you view cap rates for your own deals, factoring in additional costs or changing values, you can determine how your own deals are doing. You can do this for individual properties, and you can do this for your entire portfolio of properties as well, gaining an aggregate view of the trend of your portfolio.

So get to know cap rates. Make them one of the numbers you pay attention to in your business and practice calculating cap rates so you can build up some confidence in understanding the numbers and using them.

5 changing trends in marketing that real estate investors need to know about

A lot of the writing I do is for for real estate investors, and I do that kind of work over at my other website, Real Estate Investing Copywriter.

I recently posted a blog post over there called
Real Estate Investing Copywriting: 5 changing trends you need to know.

If you’re a real estate investor who does any kind of marketing in your biz, check out that blog post to learn about these 5 changing trends that could impact how you find buyers, sellers, tenants, and hard money lenders.

Yes, you CAN time the market (just not in the way you want)

You can't time the marketTiming the market is the most ridiculous idea out there. (Well, maybe not the MOST ridiculous idea out there but it’s pretty out there and it’s pretty pervasive so maybe it’s high up on the list).

The thinking behind timing the stock market goes something like this: “Oooh! I want to buy that stock. But the price is too high right now. Maybe I’ll wait until the price goes down.

And then when the price does go down, the thinking changes to: “Ouch! I want to buy that stock. But the price is low and what happens if I buy it and it goes lower?

This is true for real estate, too. A potential homebuyer might say: “Whoa! Houses are too expensive right now. I’m going to wait until home prices come down a bit before I buy.

But when the sellers market becomes a buyers market, the potential homebuyer now says: “Yikes! House prices seem to be declining. What if I buy and the house declines even further in value?

I hear this line of thinking OVER AND OVER AND OVER AND OVER. I heard it when I was a stockbroker and I hear it today in my work with financial and real estate professionals. I’ve tried to talk people out of this thinking but it can’t be done. (And the truth is, sometimes I fall into the trap, too!)

Like some optical illusion, the price of a stock or a property is never perfect right now and investors believe that by waiting, they can buy it at a “better” time.

Unfortunately, there never is a better time. EVERY price point has its advantages and disadvantages. Unfortunately, investors only see the disadvantages to buying now (regardless of price point) and the advantages of buying later (regardless of price point)… and they don’t seem to remember what they said only a few months ago when the price was different.

And waiting for a market bottom or market top is impossible because it takes months of data from indicators (including lagging indicators which come after the event) to prove a market peak or valley.

Timing the market is a fools game because investors and homebuyers are always looking for the perfect price point (even though they often can’t identify what that price point is and, even when they do, they fail to act when the price reaches that point).

Timing the market is ridiculous idea and a fools game… but it’s not impossible. You just have to rethink what you mean when you want to time the market.

Joe Average and Jane Average (Mr. and Ms. Average to you) try to time the market but they fail. There are people who CAN effectively time the market. I’m talking about short term traders. Short term traders (day traders and swing traders in the stock market, and real estate investors such as flippers in the real estate market) can time the market and many of them do pretty well at it.

Here’s why some people can time the market but most people fail at it:

  • Information volume and prioritization: Successful market timers do it effectively because they receive a barrage of information and they filter out what they don’t need. Compare this to Mr. and Ms. Average who glean tidbits from headlines or from the half-wits around the watercooler at break time and act on each piece of limited info that they get, as if the latest piece of information is the most correct.
  • Entries AND exits: Successful market timers consider both entry and exit positions before they buy. To a successful market timer, an “expensive” stock is still cheap if the price goes up and a “cheap” stock is still expensive if the price ends up going down. The same goes for those in real estate. It doesn’t really matter what the entry point is… it’s how much you can sell it for afterward when you are ready to sell. Compare this to Mr. and Ms. Average who likely intend to hold their stocks for decades and who will have to live in their house. They are making entry-only decisions and forgetting that there are other (hard-to-measure) aspects to owning these assets.
  • Mindset: Successful market timers view the (financial or real estate) markets as their “business”. They make money from it. Therefore, they make decisions from a business perspective. The Average family, on the other hand, is looking at buying stocks for their retirement portfolio or their next home and they are trying to weigh their decisions on a much more personal level, which makes the stakes seem higher.
  • Buying a range instead of a single price point: Successful market timers don’t look to one specific price point as THE bottom or THE top. Rather, they expect to buy a range, buying through the bottom and selling through the top and fully realizing that they might miss a few points here or there but overall they are hitting it at the right time. Mr. and Ms. Average, though, see every single low price point as a question (“is this the bottom or will it get worse?”) and every single high price point as the top (“is this the top or will it continue to climb?”). In a way, they are making a technical trading decision without any technical information.

Don’t bother trying. You cannot time the market… at least, not in the way that you want to time the market.

 

Image credit: 2020VG

INFOGRAPHIC: Home price growth rates by state

Real estate investors invest for two types of return: Income and Appreciation.

  • Income is generated from rental.
  • Appreciation is generated from buying low and selling high.

The good folks at 29doors.com and turbometrics.com created an infographic about how home prices have appreciated or depreciated by state, year over year and in the past 3, 5, and 10 years. Below the image, I’ve listed a few ways that you can use the information in this infographic.

(Click on the image to view the full-sized image).

Real Estate Investing Infographic: Home Price Appreciation By State

So here’s how to use this infographic.

  • Valuation of current investments: This infographic helps you to compare how your real estate investment has appreciated (or depreciated) compared to other properties in the state. Have your property appraised and compare.
  • Data points against other information: When you compare this data to other information about the state (economic development, inflows and outflows of people, GDP, etc.) you get an idea of the health of the state, which is particularly valuable when doing due diligence on a potential deal.
  • Identification of opportunities: This infographic shows you where the opportunities are: Prices have fallen in some places and risen in others. (Note: That doesn’t mean that the fallen prices are necessarily better places to invest — in some cases, it’s a correction back to normal). The opportunities are in the disparities between how states have increased or decreased and how your target area is doing. If a neighborhood, city, or county is lower or higher than than the state that might indicate growth or soon-to-be growth area.

Rules of the Scrappy Capitalist: Rule 2 – Find a model that works for you

Success in business or the markets used to be impenetrable unless you looked and acted like Gordon Gekko.

But the internet has become the great leveller, allowing entrepreneurs, capital market investors, and real estate investors to break in and succeed like never before.

No longer is pedigree or the “old boy’s network” a factor. Today’s success stories come from scrappy capitalists who have broken the old rules and are building businesses or investing with new tools and new information… and guts.

A scrappy capitalist lives by a set of six rules. Here’s the second one:

SCRAPPY CAPITALIST RULE #2: FIND A MODEL THAT WORKS FOR YOU

I should note first that when I say “model” I could mean “business model” or “capital market investment model” or “real estate investment model” — and sometimes other people use words like “system” or “formula” or “algorithm” or “blueprint”. I also talk a lot about sales funnels on my blog, which are a way to talk about models for businesses.

Ultimately, you’re looking for a clear, simple way to analyze opportunities and act on them to profit. Think of it as a step-by-step operational plan that you follow regularly.

For a day trader, it might look something like this (Note: This is an incomplete example for illustrative purposes only):

  1. Use a stock screener tool to sort stocks based on fundamental parameters.
  2. Narrow search to the top 10 stocks to watch for the week.
  3. Watch technical indicators for specific technical events that signal opportunities.
  4. Trade with the goal of making a minimum of $500/day without dedicating more than 25% of my investable capital into any single stock
  5. Place trailing stop-buy or stop-sell triggers if the stock goes more than 20% in the wrong direction.

A freelancer’s model might look like this:

  1. Sort projects on Elance or Guru to find the top 10 projects that apply to me.
  2. Bid on 2 projects per day.
  3. Write a blog post and comment on a minimum of 5 other blogs per day.
  4. Spend a minimum of 6 hours a day doing billable work.

Now that I’ve showed you some really basic examples, here are some tips to help you find a model that works for you, whether you are a scrappy capitalist who focuses on business, the capital markets, or the real estate market:

  • Don’t start from scratch and don’t reinvent the wheel. Find what other people are succeeding with and use it as your starting point. Build from there.
  • When looking for a model to follow, start with the experts. If I were building a value investing model, I would pull my copy of Graham and Dodd’s Security Analysis from my bookshelf (one of the best books ever, by the way) and start there. Figure out the model THEY use to invest in undervalued stocks. I can always augment but they have a great approach. As a side note, remember to only build a model based on successful models. I used to take advice from someone I respected until I realized that they didn’t actually own a successful business. Once I started ignoring their advice, my business model changed and my business grew.
  • When building your model, augment it based on what you’re comfortable with and what your skills and strengths are. When I was first starting out, I had a lot of time and no money (just like every other entrepreneur! haha) so my business model was one that leveraged all of that time I had.
  • Build measurables into your model. Your model becomes a to-do list and a way for you to make sure that you are doing enough to succeed in whichever business/market area you’re in. Early in my business, for example, I knew that I needed to send out 2 proposals per day, 5 days a week. Based on my numbers, I knew that would give me the amount of business I needed.
  • Constantly test and refine your model. I just mentioned that I used to send out 2 proposals per day, 5 days a week. That was part of my model. But as I built my business, my proposals improved and so my close-rate improved and I no longer needed to send out quite as many proposals. Soon it was 1 proposal per day. Then 3 a week. Then even fewer. All of this comes from testing and making changes based on that testing. The same goes for capital market investing: Maybe you find that you have success in junior resource stocks and, as your investing continues, you discover that you do particularly well with junior resource investing stocks that specialize in gold. Your model changes slightly to reflect that. The same goes for real estate investing: Maybe at first you try various types of real estate investing and you refine your model. Soon you discover that you prefer wholesaling houses under 1500 square feet in the midwest. As you refine your model, your business becomes leaner and more profitable.
  • If your business doesn’t have positive cash flow, there is something wrong with your model. If your business is unprofitable, there’s something wrong with your model. Go back and look at each step in your model to find out what the problem is. Some examples: Businesses without positive cash flow might be invoicing clients too late; investors without positive cash flow might not be selling with fast enough turnover.
  • If you want to change your business, you have to change your model. For years, I wanted to work a little less (because freelancing can be VERY busy work!) but I never changed my model. I had to go back to basics and retool my entire model in order to change my business.

Scrappy capitalists create their own opportunity and claw their way to the top of the success ladder. They do this by finding a model that works for them and building on it.

Stay tuned. I’ll reveal the next rule of the scrappy capitalist soon.