Comment of the Day: The Only Number I Need

COMMENT OF THE DAY: THE ONLY NUMBER I NEED “For me, as someone who routinely buys, restores, and holds these types of property for the long term (including a property right across the street from this one that is roughly the same age / type of construction), the only thing that I consider when determining value (and this a pretty standard / typical metric) is CAP rate. Specifically, I use the CAP rate at current rents and expenses to determine what it is worth today . . . and I calculate a projected CAP rate after renovations to determine what it will be worth with higher rents. The CAP rate is just a simple calculation for the rate of return on your cash in the deal. If you are simply buying a property and continuing on as is, the CAP rate is the return (from cashflow) on your down payment. If you are planning to upgrade the property the CAP rate is the rate of return on your down payment + carrying and renovation costs . . . based on the new rents.” [Jared M., commenting on The End of Another Almost Afton Oaks Apartment Complex?]

7 Comment

  • Ugh…math. Can I pay someone to do it for me?

  • Cap rate does not measure your cash in the deal or your cost of improvements. Per the wikipedia entry in the original comment, cap rate is annual net operating income divided by cost or current market value. You do not factor debt service cost in the numerator or debt you are carrying in the denominator. There is a different calculation for that.

  • Yes. COTD is confusing Cap Rate with Cash-on-Cash return.

    Cap Rate = NOI / Price. The debt portion of the capital stack does not affect the cap rate.

  • CAP is used to get an idea of a properties performance vs. others in a market. A “better” market will have lower CAPs (returns) just as any safer investment is going to provide less return.
    The trick is to find a CAP that’s higher than the quality of area would otherwise suggest. If most Montrose stuff is a 5 CAP and you can get a 7 CAP, great. However, a 7 CAP in East Houston sucks. But a 9 CAP in medical center area is great since the area is ‘better’ than the market is putting on CAP values.
    But as others pointed out, the real number that matters is your return on cash invested. If you’re all cash on a deal, that return will (should) be equal to the CAP. However, with debt you get an effective CAP on your down payment and the delta on the CAP rate – effective interest rate on your loaned money * the amount of leverage.
    So buy an 8 CAP property with 20% down at a 5% interest rate and you get not only 8% return on your 20% down, but you can 3% return (8 CAP – 5% cost of money) on what you borrowed. And the nice thing is that doesn’t equal an 8+3% return, it actually equals a 20% return as the 3% delta between loan and CAP is on 80% of the value (i.e., 4x more than what you’re in it for).
    tl;dr: Buy income property! An 8% return on a property you can buy with 20% down @ 5% interest will return ~20%. And that’s without factoring appreciation (which has a 5x effect on your down payment ROI), tax advantages, etc. Good properties are EASY TO FIND. Lending isn’t easy but if you can get financing, there is no reason not to buy *SOMETHING*. Absolutely anything is better than cash left to rot away at 0% in the bank while the fed inflates it away. Another *GIANT* advantage to buying income property is the inflation fear goes away (or really, it becomes your friend)

  • @ Cody: You forgot to mention the most important thing about real estate investment, that one should never have a partner (unless you’ve got an exceptionally spineless limited partner and you have an unmitigated asshole for an attorney). A bad partnership can make a good deal go bad with unfathomable rapidity.

    Its also important to do one’s due diligence. Little things can be important in unexpected ways. Do some title research IN ADVANCE OF THE DEAL. If there’s any vacant land, then get utilities to give you written guarantees of access to service. Look carefully at how water drains across your property and from whence it comes. Look closely at the walls, operate under the assumption of original verticality, and figure out why they aren’t perfectly vertical. What are the force vectors? And never discount the capacity of government to fuck your budget. Sometimes there will be good reasons. (You’d be amazed at how many commercial properties have electrical systems that are NOT grounded.) More often, there will be shitty, nitpicky things that need to be done. Or maybe they shouldn’t be done, but it’ll be easier to do them than fight the inspector. Are your pro forma rents REALLY achievable? Do you understand how expensive it is to re-tenant a property? (This is not a comprehensive checklist, only food for thought.)

    Contrary to what the ‘Lifestyles’ people tell you, investing in income property is hard work. It’ll screw with your head like you could never have imagined and it’ll turn you into a hard, calloused, thoroughly Libertarian son of a bitch.

    But Cody, you’re right about one thing. Getting loans is the hardest part. I wouldn’t have thrown in the towel, otherwise, in all likelihood.

  • Yes about the difficulty of financing, but I think the rest of what Niche is talking about sounds kind of over-wrought and florid.
    I have bought to renovate and sell, bought to hold and rent, bought defaulting notes to foreclose on, different angles for sure. I have some good stories but not all that agony.
    I think the key is to go for the best location you can afford.
    Yeah sure, that’s the cliche, but that’s what my small experience (dozen or so properties) taught me.
    I am not one of those Lifestyles or RICH Club etc. people– I just figured it out as I went along.

  • “And never discount the capacity of government to fuck your budget.”
    Couln’t agree more. Till we bought our 56 unit in midtown (that needed gobs of work), a tiny 4plex that had the city all over it was our most expensive property we ever had to update. Exceeding the upgrade costs of the 43 unit former Skylane down the street.
    It’ll screw with your head like you could never have imagined and it’ll turn you into a hard, calloused, thoroughly Libertarian son of a bitch.
    I’ve bought 100’s and 100’s of units, this has already happened :)