Two Current Real Estate Investment Foibles

By: Allen Cymrot

What an amazing week! There were ads in the Wall Street Journal advertising the sale of income properties with capitalization rates as low as 3.95%, and with many other properties in the 4% to 5% range. After realizing it was no joke, I opened the mail to find an invitation for a seminar that will show me how to buy property at 50% below fair market value. What I find more unbelievable then these silly opportunities is that all the properties will be sold and the seminar will be filled to capacity. Surely I can't still be on planet earth.

The second part of the famous quote "Failures are divided into two classes - those who thought and never did, and those who did and never thought," by John Charles Salak, could not better describe both examples above.

Example #1: What's wrong with buying capitalization rates between 3.95% and 5+%?

By historic standards, these capitalization rates are at the very low end (paying top dollar).

The economy is overdue for a soft to a recession period (that means the onslaught of vacancies, freebies, and lower rents).

You can purchase a U.S. Treasury Note to yield 75 more basis points.

Your debt service coupon will be more than the capitalization rate causing a negative spread (the more you borrow the more you lose).

Leverage will cause negative cash flow (you bought a failing business).

Those are the rules and that's what's wrong with buying capitalizations rates between 3.95% and 5+%. The exception for a property would require the following: Rents are below market, all leases expire within the year, rents are then raised to equal a capitalization rate that is higher the the ten-year treasury note yield, and the property doesn't have a negative spread or negative cash flow.

Example #2: How silly is it to promote buying property at 50% below fair market value? Let's look.

Assume the fair market value of a property is $100. Now someone is going to show you how to buy it for $50 (that's 50% below fair market value). Let's further assume that your down payment is $12.50 (25%). Since the definition of fair market value is the price for which you can sell a property, you sell the property for $100. That's a $50 profit. Your investment was a conservative $12.50. Your return on your investment is 400%. Actually, on an annual basis it's much higher than that. You see, since you bought the property at 50% below the fair market value, there's no holding period. You can sell it immediately. The answer to the question above is: Very silly.

A short time ago someone sent the following question to www.netgainrealestate.com: "What's the most dangerous emotion to avoid when investing in income property?" Our response was greed. That's because it blinds the logical thought process. Greed is the only reason that someone would buy properties with the capitalization rates in Example #1 or attend those seminars in Example #2.

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