Posted by joe on April 14, 2004 at 15:34:01:
Although CAP rate is a good indicator (an industry standard) for purchases of larger multi-unit buildings and complexes, I’d caution you not to depend on it for smaller 1-4 unit properties. You didn’t specify what range of units you were looking for, but I just thought I’d mention this.
It seems I’m seeing a lot of posts on this board applying CAP rate to SFRs or duplexes, and I’d caution that it’s usefulness diminishes to near zero for these properties.
The reason is that the risk is spread over a much larger number of units when used correctly. A single vacancy or major repair expense will not affect the true CAP rate very much. However, on a small property, a single vacancy or repair (outside the predicted norm) can have a devastating affect on the CAP rate.
In your example, subtracting 35% from the gross rents of a small property may be correct, or it may be extremely low. A single A/C unit replacement would obliterate the predicted CAP rate. However, on a 10-unit building, an A/C unit would have very little affect. CAP rate is just not very meaningful, if at all, with smaller properties. You can use it for one of your due diligence tools, but certainly only a minor one for small props.