Friday, September 10, 2010

Everything you need to know about the problems with investment real estate............

........in one handy chart. 

Capitalization Rates are supposed to reflect the risk and reward
ratio of investment ownership. The higher the risk, the higher the
rate.  They have not been used that way lately.

A Capitalization Rate is calculated by dividing the investment's
net operating income by the cost of the acquisition.  If you were
thinking about buying an investment property that has an annual
net operating income  of $100,000, at a cap rate is 10%, you
would pay $1,000,000. If the cap rate was 6%, you would pay
$1,666,666 for the same income stream.  A bit of a difference.

As noted on the chart, cap rates were in the vicinity of 10% in
the year 2000.  By the year 2007, cap rates had fallen to the 6%
neighborhood. 

Sellers gained.  Buyers paid too much.  Banks lent too much.
Therein lies the problem.

This blog has covered this topic before.  Real estate is not the
same as a financial instrument, yet really smart people were
benchmarking cap rates to the rates of return available from
financial instruments.  Our current economy would suggest
that was a bad decision.

From a layman's point of view, if someone offers you a real
estate investment priced at a 6% cap rate, run, don't walk,
run away.

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