When you start a sold comparable study for investment real estate, it’s often difficult to discover enough similar properties inside a narrow range of cap rates. You’ll generally find, for instance, that some properties have sold with cap rates of 5.0 to 7.0 percent and others have sold with cap rates of 10 or 12 percent (or lower or higher).

Why the wide range between cap rates?

The reason for the disparity in cap rates is because real estate investors aren’t just buying a quantity of future rental income, they also pay for quality and for the expected appreciation.

The lower the quality of the income stream and the expected rate of appreciation, for example, the higher the capitalization rate, and conversely, the higher the quality of the income stream and the expected rate of appreciation, the lower the capitalization rate. Why, because the less potential an investment property shows, the less a real estate investor would want to pay for it, and vice versa.

Okay, let’s say you compare two duplexes. One is a relatively new property located in a well-kept neighborhood near a city’s growth corridor. The other is located in a deteriorating part of town where major employers have moved out, closed, or laid off workers, and crime rates are on the increase in this area.

How much would real estate investors pay for each property?

If the net operating incomes (NOI) for these two duplexes were $20,000 and $10,000, respectively, and the investors applied a 10 percent cap rate to each property’s income stream, they would value the properties as follows:

$20,000 (NOI) / .10 (CR) == $200,000 (V)

$10,000 (NOI) / .10 (CR) == $100,000 (V)

But real estate investors would not apply the same cap rate to these very different duplexes because the quality of their income streams differs.

For example, for the better-located property, with more stable rents, less neighborhood risk, and possibly greater appreciation, the investor would select a lower capitalization rate such as 7.0; for the other (less desirable) area, the investor would choose a higher cap rate such as 12.0.

Okay, let’s compute the values for each duplex again.

$20,000 (NOI) / .07 (CR) == $286,000 (V, rounded)

$10,000 (NOI) / .12 (CR) == $83,000 (V, rounded)

Here’s the bottom line. Because most real estate investors would rather own a property in a prospering area as opposed to a declining area, they will pay significantly more for each dollar of income produced, and thus, would be willing to purchase such a property at a lower capitalization rate.

Many naive real estate investors associated with get-rich-quick real estate schemes have lost money on their real estate investments because the get-rich gurus failed to warn them that risk magnifies with the returns on highly leveraged real estate.

Too often, these poor real estate investors simply lost touch with reality and expected the market values of their properties to appreciate at such high rates that they barely cared how much they paid for the property or how it got financed.

The idea, of course, as far as the real investor was concerned, was that the investment property could get sold in a few years for twice the amount they paid for it.

We know better than that. So here are four ways you can legitimately manage the risk on your next real estate investment opportunity.

1. Don’t expect appreciation. When you need high rates of appreciation like 10 percent or more a year to make your investment look attractive, you set yourself up for a big loss.

2. Beware of negative cash flows. Unless your investment pays for itself through the income it produces, you’re speculating, not investing. If that’s what you want to do, fine, just recognize that speculating creates high risk.

3. Don’t overextend yourself. When you finance with a high loan-to-value ratio (high leverage) it usually means that you will make large mortgage payments relative to the amount of net income that a property brings in. This makes you vulnerable to negative cash flows, vacancies, higher-than expected expenses, or generous rent concessions to attract good tenants.

4. Avoid overpaying for a property. Little or no down payment deals cause many real estate investors to buy overpriced properties. The old real estate investment adage “You make money when you buy” should be memorized.

Yes, over the long term, owning real estate will make you rich. Real estate investing has made many real estate investors millionaires. But to get to the long term, you may have to pass through several downturns, and unless you have tons of cash (or credit) reserves to defend against these slumps, you’re better off remaining cautious.

When you invest in real estate, you’ll work with appraisers who will typically rely on three techniques to value income-producing properties. It would be helpful as a real estate investor for you to understand these property valuation techniques.

1. Cost Approach To apply the cost approach, you calculate how much it would cost to build a subject property at today’s prices, subtract accrued depreciation, and then add the depreciated cost figure to the current value of the lot.
2. Comparable Sales Approach To apply the comparable sales approach, you compare a subject property with other similar income properties that have recently sold. Then you adjust the prices for each positive or negative feature of the comps relative to the subject property.
3. Income Approach To apply the income approach, investors estimates the rents an investment property can be expected to produce and then convert those rents (income stream) into a capital (market) value amount.

Okay, let’s look at some examples to drive these appraisal techniques home. In this case, we’ll say the appraisal is on a 10-year old 6-unit apartment complex, in good condition, consisting of 5,000 square feet, and includes garages, decks, and sprinkler system. Nearby vacant lots have recently sold for $120,000.

1. Cost Approach Assume the building can be built for $750,000 (including upgrades, decks, sprinklers, and garages). Deduct an amount for physical and functional depreciation, which we’ll say is $50,000. Then add site improvements (sidewalks, driveway, landscaping) which we’ll say is $30,000 and then the lot value of $120,000. The indicated market value using the cost approach is $850,000.
2. Comparable Sales Approach Assume that we located three comp sales in the area that supports a value range of $120 to $130 per square foot. We would multiply 5,000 by each to establish a ballpark range of $600,000 to $650,000 for the subject property. The sale price for each of our comps would then be adjusted up or down based on such things as sale and financing concessions, date of sale, location, floor plan, improvements and so on. We would then compare the comps, after adjustments, to our ballpark range and choose the most realistic. Let’s say $590,000 to $625,000.
3. Income Approach Assume that our three comparable rental properties sold at cap rates of 5.9%, 6.0%, and 6.1%. We would use 6.0% cap rate to estimate the value of our subject 6-unit apartment complex. Let’s say our NOI is $30,000, we then divide the NOI by the cap rate to arrive at a market (capitalized) value of $500,000.

As you can see, using the three appraisal approaches to estimate the market value of a property didn’t result in the same value. This is because you always work with imperfect data. In this case, after you arrive at market value using all three approaches, you must decide which approach best serves your real estate investing purposes.