what is a good cap rate for residential real estate

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The availability of capital: Although it is not an important factor in determining the cap rate for a property, it is an important consideration when deciding what a "good cap rate" is to purchase a property. Commercial real estate buyers should avoid using debt or mortgages with higher overall costs (including origination fees) than the property's stabilized cap rate. It may be a good idea to borrow capital costing more than the cap yield to purchase and renovate a property. If the asset's stabilized cap rate is lower than the prevailing interest rates, the buyer may want to borrow less and use more of their capital. This will reduce the property's overall returns.

A solid understanding of financial concepts is essential to make smart residential real estate investments. You are not the only one who is overwhelmed by all of the financial formulas, metrics and advice available for evaluating potential properties. There is no single formula that will help you decide whether an investment is right. You can learn how to use different valuation tools and which ones to use so that you are able to identify the best methods for each prospect.

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Deferred Maintenance: This affects the overall quality of assets. For an asset with high deferred maintenance, it may be difficult to get market rents. A Class B multifamily property with a 1980s-era roof may receive market rents, but it is in need of a replacement roof at $500k. A Class B multifamily property in the same area has the same vintage, but it was completely renovated in the last six months. It is now beginning to earn market rents. Although the first asset has an excellent 12 month operating history, it still faces a large capital outlay that could impact tenants and increase vacancy. The second asset is less attractive on paper because its Net Operating Income for the past 12 months appears to be low, but it does not have any additional capital outlay. Potential buyers will be more likely to view the asset's cap rates negatively if there is a large deferred maintenance item. The buyer may find it beneficial to compare the assets to determine which investment is better.

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There are many factors that can affect the cap rate of an asset's at any time, as illustrated in the above illustration. To determine whether a caprate is "good", it requires a comparison of the asset to other assets in the same market at the time, an assessment of the capital cost and alternative investments, as well as an honest assessment of the investor’s tolerance and risk profile. There is a lot of data available that can be used to assess whether the cap rate of an asset matches the risk-return ratio of similar assets. After performing the necessary diligence and accounting for any variations in the property relative the comp set, it is up to each individual's personal goals and risk tolerance to determine what a "good cap rate" means.

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The location is a key factor in determining a property's cap rates. Real estate has a saying that "location, location and location" is all that matters. This sentiment is indicative of the importance that location plays in determining the asset's value. A market such as San Francisco2 has more jobs and commerce than a market such as Baton Rouge. Markets with higher demand result in higher property values. In other words, cap rates in San Francisco are lower and property values are much higher than in Baton Rouge.

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Lease Strength: A lease's strength is determined by its terms. These include the length of the term, the rental rate, concessions, rent increases, rent escalations and penalties, default provisions, penalties and breach, obligations of tenants (like property taxes, maintenance, and insurance) and the financial strength and ability of the tenant. An office building with Google as the sole tenant has a different risk profile than one that has 50 tenants. These tenants are all small, mom-and-pop lawyers and insurance companies. Google's corporate strength would have allowed it to negotiate a lower rate per sq. foot, lower rent rises, and more attractive terms than smaller tenants. Google's financial strength may mean that its lease is less risky than buildings with smaller tenants who are financially stable. Strong leases for all asset types - multifamily, retail, office, or industrial - will affect the property's risk perception and result in a lower caprate, which can translate into higher property values.

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Asset Class: There are three classes for each property type. These "classes" denote the quality of finishes, the strength and number of tenants, and directly impact the rents that the property can charge. A property of "Class A" is considered the most desirable asset class. It commands the highest rents, and has the highest quality tenants. This is based on creditworthiness and balance sheets. The middle-of-the pack property, a "Class B", receives average rents and has average quality tenants. A "Class C" property, which is the lowest quality property, receives the lowest rents. It also has tenants with poor creditworthiness and receives the lowest rents. The lowest cap rates for Class A properties are the highest and most valuable, while Class C properties have high cap rates but low values. Class B properties have cap rate and values that range between Class A and C. Cap rates also reflect the perceived risk an asset faces. When evaluating whether a cap rate "good", it is important to understand the asset's class and quality in order to determine if it is comparable to other assets in the relevant comparative set.