Why Do Investors Buy Low Cap Investment Properties?

When you’re investing in real estate, you hear a lot of numbers thrown around. Cash flow, net income, return on investment, and cap rate. It’s hard to make heads or tails out of all the numbers, but it should be the cap rate if there’s one number you focus on.

Many investors buy low cap investment properties meaning properties with a low capitalization rate. It may sound ‘backward’ or seem strange, but there are many reasons investors choose this path.

What Is The Cap Rate?

Cap rate or capitalization rate helps you determine the return on your investment. It helps you determine the profit potential in a property by comparing the net operating income to the property’s value.

You’ll need a few numbers to determine a property’s cap rate:

• Net operating income
• Property value

The net operating income is the cash flow you bring in from the property minus operating expenses, EXCLUDING the mortgage payment and any non-cash expenses.

For example, if your NOI is $10,000 and the property is worth $200,000, your cap rate is 5%. Whether a 5% cap rate is good or not is subjective. A lower cap rate usually signifies a lower rate of risk but a more stable investment. 

Many investors prefer to use the cap rate to compare properties or make investment decisions because it doesn’t include mortgage financing in the calculation. It focuses strictly on the property’s potential. This is important because mortgage financing can alter your cash flow/income, and if you choose a property with a higher cap rate, your lender will likely charge a higher interest rate because of the higher risk.

Knowing the property’s cap rate can help you make many important decisions about your real estate investment. 

What Are Low Cap Investment Properties?

Low cap investment properties are properties with low risk and stable income. You may not have as high of a return as a property with a high cap rate, but you’ll have a more steady income, aka fewer vacancies.

A low cap investment property has an average net operating income and property value. It’s nothing that will make you rich, but it won’t leave you broke on the side of the road either. They are usually located in metropolitan areas or high-demand areas versus rural areas or areas with less demand.

What Are The Benefits Of Investing In Low Cap Investment Properties?

Safer Investment
No investment is foolproof. You could invest in the safest investment and still lose money, so don’t get a false sense of security, but real estate with a low cap rate often has a lower risk.

When you invest in a property with a low cap rate, you may pay more for the property, but you’ll have a steady net operating income, which is what investing in real estate is about. If you could have a ‘quick win’ or a slow and steady cash flow, most investors would choose the slow and steady cash flow as it’s worth more in the long run.

Increase Net Operating Income
Net operating income isn’t set in stone. It can fluctuate the whole time you own a property - that’s normal. When you increase your property’s NOI, you increase your cap rate yourself. 

This means even if you invest in a property with a low cap rate, you may be able to increase it through the years. When you increase your NOI, you increase your cash flow and profits.

Build Equity
If you invest in a low cap rate property, you aren’t interested in the cash flow. It’s nice ‘extra income,’ but you aren’t relying on it. Instead, you’re relying on the equity you’ll build in the property. There’s room for improvements with a low cap rate, aka higher rents, because you improved the property. This builds equity in the home, increases your cash flow, and provides higher profits when you sell.

Bump up Rent
Just because you buy a property today where the average rent or the existing tenant pays $1,000 in rent doesn’t mean you have to stay there forever. If you make improvements to the property, or the demand is high in the area (common for low cap rate properties), you can increase the rent a lot easier than you could if you bought in a high cap area where rents are maxed, and demand is low. 

What Are The Downsides?

Low Cash Flow
Low cap rate properties typically have low cash flow, which is the point for some investors, but not all. You’re trading stability and security for cash flow, which if that’s not your intent, you may not want a low cap property.

Lower ROI 
You’ll likely have a lower return on your investment in exchange for the ‘safety’ of the investment. A lower ROI means you make fewer profits, but you have a much lower risk of losing it all. It’s a tradeoff that you must consider carefully.

High Demand
Buying in an area of high demand works well when you rent the property out or sell it. But higher demand means it may be harder to secure the property. All-cash buyers usually have the ‘leg up’ on the competition, but even buyers with financing will try to outbid one another, driving up the price and pushing out the ‘weak buyers.’

 

How Do You Find Low Cap Investment Properties?

Finding low cap investment properties takes a little work on your part because you need ample information about the property to determine if it’s a high or low cap. 

Here are the most common ways to find low-cap investment properties.
Work With a Real Estate Agent
Working with a real estate agent is the most common way to find a home. Be careful, though. Many real estate agents work primarily with owner-occupied borrowers, not investors. These are two different ‘balls of wax,’ and an agent used to helping only primary residence buyers may not find you the ‘best deal.

If you’re on the hunt for a low cap investment property, find a real estate agent experienced in helping investors with a similar goal. Don’t be afraid to ask the agent questions about their history to determine how they can help you. Ask about their experience buying/selling investment properties, what areas they are familiar with, and how successful the investors they helped have been with their properties.

Remember, when you buy a property from a real estate agent, the price will likely be higher because the seller must make up for the 6% commission they must pay for the real estate agent’s service.

Network and Find Sellers Yourself
Word of mouth is often the most effective way to buy low-cap investment properties. Networking is the key to success in this industry because sometimes it’s who you know, not what you know.

If word gets out that you buy houses with cash or even with hard money loans, you may come across a friend of a friend who is in a desperate situation and must sell now. It’s that right place at the right time mentality. 

You can even do some direct marketing, targeting areas you know people are selling, yet it is a high-demand area. Get the word out that you buy homes, and you may come across sellers motivated enough to skip the traditional real estate agent route and let you buy the house.

Work With a Wholesaler
Wholesalers spend their days and nights finding properties for investors. If you don’t have the time to research and crunch the numbers to find a low cap property, consider partnering with a wholesaler.

While he’s out there finding properties, you can focus your efforts on other tasks. When the wholesaler finds a suitable property, he’ll quickly put it under contract and then transfer the agreement to you (if you’re interested). He’ll increase the price slightly to account for his time and effort, so he makes a profit. Since time is money, many investors go this route, saving the time spent looking for a home and knowing they have an expert in the field location properties.

Use Real Estate Websites
If you’re a DIYer, consider using real estate websites. You can browse sites like Zillow and Craigslist, look at properties and crunch the numbers yourself or use a real estate marketplace like Roofstock Marketplace.

Roofstock Marketplace is a website designed for investment properties - they work with buyers and sellers, both of who are typically investors, helping them find the perfect investment home or get the most money when selling their investment property.

Using Roofstock Marketplace offers a few unique benefits:

• Buy turnkey properties - Many of Roofstock’s listings are turnkey properties or properties with tenants in them. When you buy a turnkey property, you buy a property with an active lease (and tenants). You become a landlord the day you buy the property. You don’t have to search for tenants or even come up with a lease - everything is done for you.
• Numbers are crunched - The most significant part of buying a real estate investment is crunching the numbers. Figuring out the cap rate is one aspect, but there are many other numbers to crunch, including the net operating income, cash on cash return, gross yield, net cash flow, and more. Roofstock provides this detailed information for every property they list, taking the work off your shoulders.
• Support through the buying process - When you buy a property off Roofstock Marketplace, they do all the work and support you along the way. It costs buyers only 0.5% of the sales price, and a Roofstock representative is with you the entire time you buy a property, answering your questions and helping you navigate the sales process.

How To Decide

Choosing between a low and high cap rate property is a personal decision, but here are some questions to ask yourself:

• What is your risk tolerance? High cap rate properties have a higher risk of vacancy and/or default. If you’re willing to take that risk, a high cap rate property is a good option. If this is your first real estate investment or you have a lower risk tolerance, sticking with low cap properties is best.
• What are your goals? Are you investing for the long term? Is this property meant to bring you steady cash flow or quick profits? The answer will help you decide if a low cap property is a better choice. If slow and steady with low risk is your ‘sweet spot,’ then a low cap rate may be right for you.
• Do you like investing in metropolitan or high-demand areas? If you’re the type that wants a property in the middle of it all - a low cap property may provide that. If you like properties that are more hidden and may not have such high demand, a high cap property will be a better choice.

The Bottom Line

It’s a personal choice deciding between a low cap and high cap property. There is no right or wrong. Instead, look at it from your point of view. What do you want from the property? What type of risk can you take?

Slow and steady often wins the race, and if that’s your pace, join the club of low cap real estate investors and enjoy the steady gains.

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