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Cap Rates vs Appreciation – The Quandary

Cap Rates vs Appreciation - The Quandary

So you’ve already made the decision that owning rental properties is the best solution for long term wealth. The question now becomes, what should be your goal.

Quick definitions for readers less familiar with the terminology I will be using in this post.

Appreciation – The growth of the value of an asset over time.

Cash flow – The amount of money you make on a rental property after all expenses are paid.

Capitalization Rate (Cap Rate) – The net operating income of a property (before debt) divided by the purchase price of the property.

Some investors are seeking cash flow as their primary motivation. They are looking for the highest cap rates possible so that they can make money now. Other investors seek appreciation and are willing to make their money down the road when they sell for a sizable gain.

Unfortunately in most cases, there is an inverse relationship between these two investment objectives in the residential real estate space.

Single family homes are by far the most likely to experience considerable appreciation. They are the most sought after as a rental, and they have considerable value to an owner occupant at the time of sale. They are also the most liquid type of real estate because of the sheer demand for them.

There are a couple of downsides to single family. They tend to cost more because there is more competition for this asset type. Not just from investors but from actual owner occupants. You have more to take care of maintenance wise so there is additional risk. There is no economies of scale with a single family home, so managing it is a little bit more challenging. Lastly, there are more expenses associated with keeping up the exterior, property taxes, insurance and others that cut into the short term profits of this asset type.

Multi – Family is the asset type that is most known for cash flow. These are typically sold at a considerably higher cap rate than a single family home. These are typically sold by and between other investors. The majority of the way that their value is derived is by their ability to produce a return to the owner.

One of the benefits of multi family is that by having more than one unit, if there is a vacancy it will affect you marginally less. Another benefit is that there are some economies of scale when it comes to managing and taking care of lawn / snow maintenance.

The downside to multi family is that they are generally less desirable to the top tier tenants who’d rather not share common walls / space with other tenants. Desirability of the location will have a major impact on whether or not the multi family home you are looking at is a good investment or not.

Townhomes / Condos are asset type is some what the hybrid of the first two. Like a single family residence, they are often sold to actual owner occupants, which increases the demand, and the appreciation potential.

Unlike single family homes, they can often be rented at a higher cap rate because the demand is lower than for single family. Other advantages are that these property types are often kept up and managed by an association. Some view the association fee as a detriment to the cash flow, but I see it differently. I consider the value associated with keeping the exterior, the landscaping, insurance and other important considerations being taken care of for me as a benefit. Certainly the more properties that you acquire the more simplicity becomes a motivating factor.

Conclusion – Now that we have briefly touched on the asset types, pros and cons of each, and the inverse relationship that exists. What does this mean for you?

High Cap Rates – If you are looking to invest a large sum of money and live off the income, than you know that a higher cap rate is what you need to seek. For you, it’s all about that monthly rental income that you will use to sustain yourself.

Appreciation – If you have a job or other source of income and this is just part of your retirement portfolio or you just want to wait to cash out down the road, then the appreciation could be your best play.

Hybrid Approach – Some investors like myself, like to try to spread it around pretty equally among all three types. By hedging in this way, you get some of the upsides of each. You are not completely saturated into to one asset type should the market turn for the worse.

Thanks and let me know if I can help you with your investment goals