The One Metric Far More Important Than Cap Rate or ROI for Real Estate Investors
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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