If we use the definition of an asset by Robert Kiyosaki in his book Rich Dad, Poor Dad, an asset is something that makes you money. Conversely, a liability is something that costs you money. Therefore, an investment in a real estate asset is something that makes you money. If you are buying something that makes you money, how do you come up with a price you are willing to pay for that investment? In today’s current state of the market, prices are going up very fast. Why? In my opinion a few different forces are at work. Our real estate market crashed in 2008. This caused most people to distrust many investments, including real estate. The resulting crash also wiped out many individuals’ savings and any equity they may have in their real estate assets. The government and the Fed created a stimulus by injecting billions of dollars into the economy. That additional capital propped things up and created stability, but the capital sat on the sidelines doing nothing. Now that we have a pro-business president in the White House, there is confidence in the market and big capital is moving off the sidelines and into the market – which causes prices to rise. Now, everyone sees real estate going up in value and they want in as well. However, there is more happening than you may realize… We now need to discuss capitalization rates, or the “cap rate.” To over-simplify, a cap rate is the return on investment someone would receive if they paid cash for a property. Similar to a certificate of deposit or annuity, a $100,000 CD that pays $3,000 per year has a 3% yield. If this were an investment property, a $100,000 purchase price that created a $3,000 net operating income would have a cap rate of 3%. Note, however, that ownership of real estate assets comes with other massive benefits you would not have in the CD (or many other investments). These include appreciation, leverage, equity capture, and tax benefits (which effectively increases your yield). Assuming that the cash flow does not change, as the cap rate changes, the value of the property goes up or down inversely to the cap rate. Let’s assume that a property has a $100,000 net operating income. If the cap rate is 7%, the value of the property is $1,428,571 ($100,000/.07). Again, if you pay cash (meaning there is no debt service) and there are no capital expenses, you will have a $100,000 cash flow for your ~$1,429,000 investment. Now, let’s assume that the market gets hotter and cap rates go down. If the cap rate is 5%, the value of the property is now $2,000,000 ($100,000/.05). The value of the property just went UP by $500,000 simply because the cap rate went down – not because the cash flow produced by the property changed. Here is the biggest problem I see at this time – every investor is a hero over the last few years. Like the example above, the buyer did nothing to increase the property’s net income (cash flow), they just got lucky that the cap rates went down and increased the value of the property. This is important. They did nothing to the property and the value went up ~33%. They look like brilliant investment heroes. The price of an investment property is dictated by who will accept the lowest return on investment – which makes the price higher. Investment properties the last few years have generally not been priced, the brokers say the price is determined by the market. Meaning, they are seeking a vast pool of buyers to bid up the price. This too will change, but the market is currently hot, so prices are up and cap rates are down because of all the demand for investments. If you are an investor, especially a passive investor, look at the future assumptions. Cap rates will go up. If the sponsor projections use a lower or the same going in cap rate, beware. No matter if the market is up or down, it is still good to buy – if you are buying for cash flow! When investing, we are really only buying a stream of cash flows!