Yesterday, we talked about how to calculate the cap rate – a very, very basic figure that can help investors compare one property to another on an apples to apples basis.
Now, let me tell you why you should be a bit judicious in your use of cap rate as an investment measure.
On single family detached homes, cap rate works best when the homes being compared are relatively similar. Since the Phoenix real estate market is dominated by tract homes, the type of home involved – build quality, construction standards, etc. – are roughly the same across the board. (Some builders may disagree vehemently, but that is what marketing departments are for.)
Working within the same city, or pair of cities for the multiple sister city-pairings here in Phoenix – Glendale and Peoria, Avondale and Goodyear, etc. – and looking at the same era of home, using cap rate can allow an investor at a glance to value one property against the other.
But as differences increase – the age of the home or the existence of an HOA, for example – the cap rate becomes a little less useful. In fact, it’s not uncommon for the home with the lower cap rate to be the better rental property.
Real life example time …
Property A was built in 1982, is listed at $65,000 and would rent for about $700 a month. We’re going to use 25% as the total expenses – vacancy, repairs, etc. – and there’s no HOA.
700 x 12 = $8,400 … $8,400 x .75 = $6,300 … $6,300 / $65,000 = 9.7 percent cap rate
Property B is two miles to the west. It was built in 2004, is listed at $125,000 and would rent for about $900 a month. We’ll use the 25% again for total expenses, which in this case includes a $63 per month HOA. Theoretically, though, repair expenses should be less in an eight year old home versus a 30 year old home.
900 x 12 = $10,800 … $10,800 x .75 = $8,100 … $8,100 / $125,000 = 6.5 percent cap rate
So, of the two, which one is the better investment? (If you’re jumping up and down screaming “neither!” that’s okay. I’m not going to disagree with you. Not at all.)
Looking strictly at cap rate, Property A is offering a fairly good return … Except …
- The home was built in 1982
- Major replacements are coming up unless they’ve already been done – roof, air conditioner, water heater, appliances all are well past their expected life cycle (in some cases twice over) and a home warranty won’t necessarily cover everything coming up
- There’s no HOA
Buyers looking for owner-occupied properties often try and avoid HOAs if only because they don’t want some pencil pusher in a little office somewhere telling them that their lawn is 1/4-inch too high.
But for investors, an HOA is your best friend for the same reasons municipalities out here require builders to create an HOA – assistance with code enforcement.
While the HOA can’t help you with what happens in the backyard below the fence line or inside the house, it does require basic upkeep of the front yard. (Best way of having the tenant feel the importance of this it to include in the lease that the tenant is responsible for any HOA fines.) And, theoretically, if they’re keeping up the front than the hope is they’re keeping up the rest of the house as well.
In addition, the presence of the HOA in a normal market will help property values. It’s not difficult to notice the difference in an HOA and a non-HOA neighborhood at a quick glance, and those difference often translate to real dollars in property value and appreciation.
Short story long, if you’re looking at properties here in Phoenix with a higher cap rate, there’s likely something happening there that might make you want to think twice.
One last note … I mentioned those new builds in Glendale at a 9 percent or so cap rate. With a more realistic, more conservative repair allowance included, the cap would be a bit closer to the mid-7s. Which, for the reasons outlined above, would be a better bet than a much older, much less expensive house that’s going to come with more expensive headaches.