Or should I be asking, “DO YOU evaluate the performance of your investment real estate?”
For the past several years we have been helping our clients to understand how this important asset in their portfolio of investments is performing relative to income producing real estate in general, and their situation specifically. We have come to notice that most people do not evaluate this asset on a regular basis, and therefore, do not benchmark or determine the opportunity cost for their real estate.
What’s ironic about this complacency is that for most people their real estate holdings represent an overwhelmingly large percentage of their overall assets. In some cases real estate represents the vast majority of their assets. Quite frequently we will have meetings with clients to review their marketable investments and their tax situation and find they are on top of the performance of their account and saving taxes, and for good reason. Unfortunately, however, most seem to pay no attention to the performance of their biggest asset by far…their income producing real estate. With inherited property it can be even worse.
In the San Francisco Bay Area we have seen incredible growth in real estate values since the end of the financial crisis in 2009. Unfortunately, we have not seen the percentage of yield, or “Cap Rates” go up commensurate with the equity value owners have been so happy to receive.
It’s no coincidence that over this same period of time the owners of investment real estate have seen a cascade of additional regulation on them as landlords. Banning Airbnb, rent control, restricted eviction justifications, requiring subleasing, and more threatened on the horizon.
Additionally, it has also been well documented that the income levels in the SF Bay Area are simply not keeping pace with the cost of living in the Bay Area, including housing. Therefore, even if a landlord was allowed to raise rents to try and maintain a competitive percentage yield on their equity, most likely they would be pricing themselves out of the market and experience extended vacancies.
So, you’re stuck. (I’ll explain later that you’re not stuck. You have options.) You’re happy and excited about the equity value in the property going up dramatically, but you can’t benefit from it very much in your monthly bank account level and spending enjoyment. It’s not benefiting your lifestyle at all.
What’s Cap Rate?
“Cap Rate” is industry jargon for the term we use for the percentage rate of return you are receiving on the equity value of your property. It does not include things like debt, depreciation, taxes and insurance. Most of the time people calculate cap rate based off the original equity in the property from when they bought the property. That may make sense when you are making the decision to buy the property, but, in my opinion, this makes no sense at all when you are evaluating and benchmarking the performance of your property as a going concern. It’s a business and I want you to think of it as a business and thus evaluate it as a business based on the current market environment; not what the environment was like when you or your elders bought it 10, 20, 30 years ago or more.
I like clients to think of this term as the level at which you are capitalizing on the current equity value of your property.
If your cap rate when you bought the property was 8.0% and the value of the property has doubled since you owned it and you’ve only been able to raise rents 3.0% annually, then it’s easy for us to see that the income is simply not keeping up. If we extend this scenario out to a 20-year ownership of the property we begin to see that we have a great asset, but where’s the love with income?
What are the trends we are seeing?
The trend we are seeing is very consistent in almost every county in the SF Bay Area…cap rates are generally speaking at historic lows. According to Compass real estate cap rates for 5+ unit multifamily real estate has been consistently falling since 2011, where they topped out at 6.0%, and ended 2018 at 3.9%. 2019 looks to have been a bit better, but still far below historic levels.
What are good benchmarks?
It’s hard to put hard and fast benchmarks on individual investors thresholds of what is acceptable performance with their investment property and what is not acceptable. Each of our clients have different stories, histories, goals, risk tolerance, legacy, needs, etc. etc. for their investments, especially real estate investors. So, let me give you some general guidelines we like people to consider and then let’s adjust based on your situation.
Generally speaking, depending on your situation, at a minimum, we want you to have the following cap rates based on the current estimated equity value of your investment real estate:
- Managed by you: 8.0% - 10.0%
- Managed by property manager: 5.0% – 7.0%
As you can see there is a premium for you managing the property – there should be. You’re dealing with the hassles, time, repairs and maintenance, tenants, toilets, trash, etc. The other consistent trend we are seeing is Baby Boomers are sick and tired of managing their property. They’ve reached an age where they want to enjoy this time in their lives and do not want the hassled and stress that comes along with managing their real estate.
The answer is passive real estate ownership.
Given the importance of investment real estate for people, Eckhoff will be holding a series of events throughout 2020 to do our part to educate the public about options for securitized passive real estate investment opportunities. This is commercial and multifamily real estate managed by professional real estate companies and is available for only qualified accredited investors.
The popularity of doing tax-deferred 1031 exchanges into this type of ownership has been skyrocketing in the past 5-7 years. As more and more Baby Boomers reach retirement age, we expect this trend to continue.
“This is a very viable option to answer the needs of many real estate investors in the Bay Area to help them improve their situation and achieve their goals.” Patty Hyun, Sotheby’s Real Estate.
Our mission at Eckhoff is to help our community by helping our clients make an even greater impact on the people and causes they care about deeply.
By helping people understand their options and the advantages, disadvantages and costs of those options we are helping people make good decisions in order for them to make that impact. Understanding how the largest asset in your portfolio is performing and, perhaps, how to improve upon that performance is the first step to making those decisions.
To learn about your cap rate and how your real estate fits in to the rest of your wealth planning, please do not hesitate to contact us.
Bruce Frankel © 2019
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