When starting the journey to real estate investing, figuring out how much to buy a property for is a daunting task. When I first started, I thought I was going to make crazy, unrealistic returns. Unfortunately, a 25% cash-on-cash return on multifamily real estate in Houston, TX, is not commonly found.
So, this begs the question: What types of returns should investors expect, and how much should investors pay for real estate?
I’m going to tell you what I wish somebody had told me.
Value is relative from person to person. There is no fixed price that a property is worth; instead, it is all in the eyes of the beholder. You have to work backward to figure out what a property is worth to you. First, you must determine what type of return you want and then outline a plan to achieve that. If you want some help and guidance regarding your specific situation, schedule a call with us, and we can share some of our thoughts.
With that being said, there are ways to understand what people are paying for real estate in different sectors and markets. You can then use that information to determine which sector, if any, of real estate is best for your goals. If your goals differ from those that can be achieved regularly with traditional real estate investing, other investment vehicles may be better suited for you. Investing is all about figuring out how to get to where you want to be.
The Income Approach & Capitalization Rates for Investors
Market Capitalization Rates, which is just a more formal term for the expected cash-on-cash return without any debt, gives us a great insight into what others are willing to pay for real estate. By understanding the market capitalization rates, or cap rates, investors can easily estimate what the market values a property at with this handy equation:
Imagine you're exploring hotels in Houston and come across an exciting deal with a net operating income of $500,000. To get a sense of the property's worth, simply divide that net operating income by the cap rate of 9.4% (from Crexi Intelligence). This way, you’ll find the market value of that hotel is roughly $5.3 million.
These market cap rates vary widely depending on the area you are buying in and the risk associated with that location.
People will take lower returns for lower risk. For instance, if you buy real estate in Manhattan, you expect the risk, and thus the cap rate, to be lower than if you buy real estate in a small town in Kansas.
Put simply, cap rates are also an indication of risk. The higher the cap rate, the higher the market deems the risk to be. The lower the cap rate, the lower the risk the market considers.
Let me explain this further by providing an example. Let's create a scenario where you are on the hunt to buy some real estate. You have two options: one is a house that generates $95, and the other is a house that produces $100. Other than their income, they are the same house in the same neighborhood. Which one would you choose? Obviously, and hopefully, the one that makes $100. In other words, you value the house that generates more money higher.
Now, let's take that same example, but instead, the $95 house is in Manhattan, New York, and the $100 house is in rural Salinas, Kansas. Which one would you choose now? This becomes more difficult to answer because there is less risk in renting out a house in Manhattan than in a smaller rural town. It is extremely unlikely that rent would cost less in Manhattan than in Salinas; however, I hope this example helps you understand that if the risk is higher, then one will expect a higher reward.
Investors can also use capitalization rates to compare the return for different real estate investments. Keep in mind that when you use cap rates to compare investments in different markets or sectors, there will not be an indicator of risk. Because you are comparing apples to oranges, you will only be able to compare financial output.
By rearranging the cap rate formula, you can compare returns from different real estate investment opportunities. The higher the cap rate, the higher the expected return.
Conclusion
The value a property has is not concrete. It really does vary from person to person. Some people are looking for extremely low-risk investments for wealth preservation, while others are looking for higher returns to build wealth. You must figure out what goals you have for your money and invest accordingly. Cap rates are a good, basic way to value real estate, but they can be misleading.
In my opinion, you must look at the intangibles. Intangibles like, is the area growing? Why is there a demand for that piece of real estate? If you rewire your mind to think like this, you will find asymmetry in higher cap rate markets that have less risk. Informational asymmetry will lead to higher rewards with less risk.
If you have any questions regarding cap rates, please feel free to schedule a call with us. If you want to learn more about hotel investments, click on this link to access more resources.