Let’s say you want to purchase an income property as an investment. As you conduct your search, you are likely to find that the stated property values are largely based on cap rates. While a cap rate is a decent baseline indicator of a general value range, it is typically not a reliable or accurate representation of the true long-term value of a particular property. There’s not an exact standard or consistent method for applying a cap rate – the factors and formulas used can be somewhat arbitrary.
Cap rates are solely based on property income performance for the current year. Cap rates don’t take into consideration factors that may affect property values five years or 10 years down the road. Because cap rates only deal with what a property is producing now, it’s a very shortsighted and narrow view of property value and should not be the number on which you ultimately base your purchase price.
I sometimes view cap rates as they relate to real estate the same way I consider the list price of a used car to its true value. Let’s imagine you’re in the market to buy a used car for your child’s 16th birthday and you’ve budgeted $4,000. You and Junior walk on to the lot and see some used cars with sticker prices of $8,000 or more. While you realize that the dealer will certainly sell the car for less than $8,000, you also know that he or she will not go down to $4,000.
You walk past those cars until you see some options in the $4,500 to $5,000 range. Now Junior sees a car he loves and yells, “That’s the one I want!” So you get on your smartphone and pull up Kelley Blue Book to get an idea of what the car should be worth. At first you just put in the make, model and year and the formula calculates an estimated value of $5,500. But then you enter more data. More than 130,000 miles … bald tires … heavily worn upholstery … multiple dents from obvious fender benders … and now a more accurate valuation of the car shows that it’s not worth $5,500, it’s worth closer to $3,900. Whew! Aren’t you glad you took those other factors into consideration before agreeing to pay the sticker price or a price that was more than the true value of the car? So in this example, the sticker price is a decent indicator of price range, and can guide you to the right section of the car lot, but you need more information before you really know the value of the cars with any degree of accuracy.
Cap rates on income properties are often like the list price of a used car. They can be an indicator of the estimated value of the property and give you a starting point for your search, but there is more information and more work to be done before choosing a property and making an offer.
Understanding the true, long-term value of a property requires a thorough analysis done by an expert who knows from experience what that analysis should include. There are many factors to consider when determining and fine-tuning property valuations. Here are a few of them:
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