1 Metric Far More Important Than Cap Rate Or ROI

We’ve all seen the data… Cap Rate, Cash on Cash, Return on Investment, but have you considered a true FYROR?

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As I’ve worked with investors over the years, it doesn’t cease to amaze me at the number investors looking strictly at Cap Rate, or another short term analytic. Cap Rate, ROI, and the others seem to be more like the stock market, only concerned about the next quarterly report on earnings. Many investment professionals, including Warren Buffett and the like, are deeply concerned about the long term plan.

I contend that a Five Year Rate Of Return (FYROR) is a better analytic that needs to be considered. An investor may buy a property on the cheap that turns a good monthly rent rate, but may have high turnover costs, repair costs, etc. Consider these strategies:

‘A’ Grade Property, $100,000 ARV, $1500 rent with typical expenses, stays on average of 2 1/2 years, and causes typical wear and tear, with turn costs of $2500.

‘D’ Grade Property, $25,000 ARV, $750 rent with typical expenses, stays on average of 1 year, likely needs a costly eviction 1 out of 5 years, and causes significant damage at nearly each turn, an average of $3500 as well as higher on-going maintenance calls. Expenses, expenses,…

Use your own analytics to determine which property class is going to yield the better long term return after factoring extra vacancies, turn costs, maintenance costs, eviction costs, etc.

On the surface, looking at just the investment and the rent rate, the ‘D’ Prop looks great, a substantially better investment. However, the ‘D’ Prop will have higher capital expenditures, higher vacancy costs (5x vs 2x), higher rehab costs and potentially a costly eviction.

So, before looking at your next buy and hold deal, consider your FYROR. It may tell a compelling story to reconsider your front end rates in exchange from a stronger long term return.
Photo Credit: Marquette La

Diana Cruz

Replied about 6 years ago

Thank you for that input. This is just a blink of what I am looking for. I am just starting to structure my investment strategies and was considering go with multi family rentals. I have been looking at a few different units and analyzing the numbers but seem to feel as if I am missing something. With what you just mentioned about the analysis of a 5 yr Rate of Return it dawned on me that I am on the right track. I just need to now what I need to facture in so that I can come up with the right offer price and the numbers work out for me. I was working on a spread sheet yesterday and got baffled with all the number and still feel as if I’m missing something. But thanks for the input.

William Robison

Diana– Thanks for the comments. Im a believer in analysis, but Im not much for reinventing the wheel. Have you looked at the resources on the BP? There are some solid analytical tools available. Check out https://www.biggerpockets.com/files All the best with your investments.

Thank you I will definitely see what’s available.

Tom Waddell

William, thanks for an thought-provoking article. Also, I’m still fairly new to Bigger Pockets and wasn’t aware of the Files posted here. The spreadsheets are fantastic. Thought I had to do this myself, so thanks for the callout!

Alex Craig

You nailed it. I agree 100%. A class properties in the long run more often the not will perform better. I have seen too many people lose money on debt free properties in C and D class areas. Then their is a morale cost when you have to hassle with these tenants, go through evictions and wait on the police to file reports when the house gets vandalized. I manage a few C and D class properties and as they go vacant, we let them go.

Hi Alex good info here. I would like to ask a question regarding those properties. Now the C and D would mean low income and middle income or is it a grade you give the properties. I’m new to this so I’m learning the terminology and ropes. and once they get rid of the properties are they not profitable or is it that you just don’t want to deal with the hassle ? I ask because I am looking to see if I can get a few rentals and have looked at two different locations that have from 11 to 16 duplexes and quadroplexes but the area does not look very good and the units are old and need renovation. I am doing my due diligence and analyzing everything possible. I want it for a long term and don’t want to end up paying more than what I make. Also would a 2.5 to 7% cap be a good investment.

Diana Yes, A, B, C, D and sometimes F are properties ratings. There are no hard and fast rules as to what costitutes a certain classification. This is due in part to differences in markets. CA and MO are going to have far different property values for these certain classes. In response to the cap rate that you mentioned on those properties, its still going to depend on appreciation factored as well as property classification risks. If they are C or D, these numbers would be far too low for the majority of investors.

Thanks Alex for the response. Its a rather solid concept that is often missed, even by the largest hedge fund buyers in the market, but that is a whole topic itself. Finding solid properties that will have a positive return for the long run really should be the goal of the investor. Otherwise, another market correction at the wrong time can put them into a bad situation. All the best with your investments.

Dawn Anastasi

I personally like the hybrid … “C” class property with $25,000 entry price and $40,000 – $50,000 ARV. Tenants stay 2-3 years; typical expenses when things break; cause normal wear and tear but nothing more than a few hundred dollars to clean up and get rent ready again. Rents in the range of $750-$900.

Dawn That can be a popular value range, but it largely depends on the market. There are lots of successful investors in my market and likely your for that value range. Most important for those will be good property management.

William Shaffer

Good work. You put into numbers what I have felt for years but was unable to convince the guru graduates of who were buying junk in the hood because the “numbers” looked good. Reply Report comment

Good work. You put into numbers what I have felt for years but was unable to convince the guru graduates of who were buying junk in the hood because the “numbers” looked good.

Thanks William Its hard to convince an investor that doesnt have their own boots in the trenches what those differences can really mean for their bottom line in the long run. Proper analysis from sellers with intergrity will get you to the right conclusions based upon your goals.

Kyle Hipp

I am not aware of anything I would consider a warzone in my area so I believe that best practices in management really makes the difference. I can definately imagine a neglected area causing problems but strong management can make up for a lot.

Jonathan La Rosa

Couldn’t agree more. Numbers are just numbers and though a particular set may be enticing on the surface, it is best to dig deeper and get the overall big picture before making a decision. This wasn’t mentioned, but I think owning a rental property in a predominantly owner-occupied neighborhood greatly reduces those extra costs (extra vacancies, turn costs, maintenance costs, eviction costs, etc). The quality of tenant that is seeking to live in this kind of a neighborhood will usually have kids and is looking for a good place to raise them. Somewhere where the schools are good and the crime rate is low. There is generally pride of ownership in these neighborhoods and a sense of community which also attracts this type of tenant. Although some (if not all) of these costs are inevitable over time for ANY long-term buy and hold, with all else being equal, I believe that these costs are greatly reduced for owning property in owner-occupied locations.

Jonathan That is a great added point about the tenant/owner occupant ratio. It is certainly another metric that quantifies the property grading. Thank you for the input. All the best with your investments….

Susan Gillespie

What is the the formula for FYROR? Do you mean internal rate of return, modeled over five years? I agree that a 5, 10, 15 year or more evaluation is a strong indicator, combined with a solid understanding of income and expense projections. Evaluation needs to include realistic rents and expenses, including vacancies and repairs.

Everyone uses a slightly different calculation to determine their rate of return on investment. My point was that an investor should calculate their returns based upon the long-term and factor true anticipated costs in association with the level of property.

Frost

Of course long term value needs to be calculated and any half-smart investor will do so. The reason investors look so closely at other metrics (Cap Rate, Cash-on-cash, etc) is because those equations have a universal equation, unlike FYROR. I guess the take-away here is that every investor should build a model in Microsoft Excel so they can adjust term lengths, turn costs, vacancy rates, and probably eviction costs. Then run that model out 5 or 10 years. -Frost

Shaun

It is certainly true some investors get lured into tough properties in bad areas based on returns based on unreasonable numbers (not factoring in higher vacancy and repairs etc). However I also see people that buy higher priced properties just use these harder to quantify factors to justify to themselves why they get lower yields on the surface. There is value in less hassle which will usually come with these as well as better appreciation potential. However neither is a guarantee so you are just betting on better odds. My nicest place is in a great neighborhood with lots of amenities, lots of employment and great access to public transportation to get into the heart of the city in minutes. Rents are about 50% higher than my next highest units. All my tenants have been well educated professionals with great jobs. Never had any real problems and under different circumstances we could be friends. It has low vacancy and turnover costs are often zero. I’ve never made a dime on it. My super cheap places in places I’d never particularly want to live can sit vacant for 6 months a year and I’d still squeak out a small profit.

Shawn- Those are certainly valid points. Im sure that you took careful analysis on the property that “you dont make any money on” when you bought it, and likely have some appreciation to count on in an improving market. Self-managed properties tend to have a lower cost basis on B-/C+ properties and likely can generate great returns. A/B+ Props need to be bought at a discount to justify their value and with patients can be found in the right markets. Oftentime, these properties will not generate short term cash flow, but yield profit from the lessee paying the mortgage and realizing appreciation gains.

I will admit that my analysis was not great on that place as it was the first one we ever got so there were missteps that we would not make now. That being said I don’t see really anyway to but in that area in general that would work. Also not to make it a pity party but since we bought it in 2004 it is only back to roughly what we paid for it, so those great appreciation we had read about hasn’t happened yet. No plans to sell it since the rents have actually gone up a bit recently so it should actually make a little cash flow and maybe after owning it for more like 15-20 years we will get the “nice area” better appreciation. As you allude it is quite difficult to get nicer homes to work you have to get them at big discounts and they still often don’t cash flow well. In those instances you are banking on appreciation. As the experience I described (and that of many people that bought really poorly in the boom) it is no sure thing so be prepared to carry it for a long time if you need to.

Frankie Woods Investor from Albuquerque, NM

Replied about 5 years ago

Hm…I really like this metric. I will have to incorporate it into my overall analysis! I’ve been purchasing a lot of C- properties in St. Louis, so this article is especially relevant to me. Thanks!

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