Would you do this deal?

25 Replies

Hi all – just about to sign on the dotted line and wanted to get your take on the property listed below. This is actually just one of a few properties that I’m purchasing in Cleveland from an off-market portfolio, but the numbers are largely the same. The property is located in a B+ neighborhood and is close to two universities and the Cleveland Clinic.

The cap rate is great, but i'd be interested to hear if others are demanding more sizable cap rates in Midwestern towns. 

Purchase Price: $83,000

Annual Rent: $19,200 ($1,600/mo)

Vacancy @ 8%: ($1,536)

Gross Income: $17,664

Taxes: $2,633

Insurance $441

Maintenance @ 8%: 1,766

Utilities: $500 (tenants cover ALL utilities, but figured I’d add it in there)

NOI: $12,325

Debt Service: $3,648

Cash Flow: $8,675

15.4% Cap Rate

Your maintenance costs are 8% of...?

I would factor in 10% property management even if you plan on managing yourself. You may not want to one day. That gives you a CAP rate 12.7% .

Originally posted by @Zoran M.:

The cap rate is great, but i'd be interested to hear if others are demanding more sizable cap rates in Midwestern towns. 

NOI: $12,325

15.4% Cap Rate

 @Zoran M  On what basis do you think your anticipated cap rate is great?  Also the market sets the cap rate so how do you think someone can DEMAND a more sizable cap rate? 

Not knowing anything about the neighborhood or expected appreciation, deferred maintenance of the property, age, type or current condition. I usually run my Repairs at 10% and factor in Capital expenses anywhere from 5-10% depending on age, and older property I will give 10%. I would also have to have a property manager at 10%. So it would be a 10.5% cap for myself. 

The number look pretty good to me, I have not found a SFR in the 80's that rents for that much. Looks like @Bob Bowling  doesn't like the numbers, I would be interested to know why?

Originally posted by @Nick Fitzpatrick:

Not knowing anything about the neighborhood or expected appreciation, deferred maintenance of the property, age, type or current condition. I usually run my Repairs at 10% and factor in Capital expenses anywhere from 5-10% depending on age, and older property I will give 10%. I would also have to have a property manager at 10%. So it would be a 10.5% cap for myself. 

The number look pretty good to me, I have not found a SFR in the 80's that rents for that much. Looks like @Bob Bowling  doesn't like the numbers, I would be interested to know why?

Where did I say I didn't like the numbers? And what numbers do you like or dislike? First we don't know what type of property he's talking about. You stated SFR and came up with a cap rate. Any knowing investor knows cap rates are not appropriate to use for that building type unless they are trying to pull a fast one on an ignorant buyer.

But as far as liking the numbers based on what is presented. Well the market is saying it will only pay about 4 times the gross rents. Why would that be? The market is saying that they don't expect to see much of that gross rent in their pocket. Think little pockets! So just based on the GRM I'd say it's a pretty bad deal no matter where it is located. If it is a multiple family the cap rate ( If it is actually a market rate and computed correctly) is saying that the market doesn't consider the NOI that desirable. That can be for many reasons.

Also the correct way to use a cap rate is to get the market cap rate and divide your NOI by it to get a purchase value.

Originally posted by @Bob Bowling:

You stated SFR and came up with a cap rate. Any knowing investor knows cap rates are not appropriate to use for that building type unless they are trying to pull a fast one on an ignorant buyer.

Why is that? Seems logical to me to be able to calculate and apply cap rates to an SFR. If anything, it's a great way to compare deals between each other, but I don't see the reasoning of why it's not appropriate for SFRs.

Originally posted by @Avi M.:
Originally posted by @Bob Bowling:

You stated SFR and came up with a cap rate. Any knowing investor knows cap rates are not appropriate to use for that building type unless they are trying to pull a fast one on an ignorant buyer.

Why is that? Seems logical to me to be able to calculate and apply cap rates to an SFR. If anything, it's a great way to compare deals between each other, but I don't see the reasoning of why it's not appropriate for SFRs.

Please give an example how you ACTUALLY do this and I will show you how it doesn't work.  Rough figures are OK.

just based on the rental income and price, its a good deal ,,of course the other things mentioned above, deferred maintenance etc, should be taken into account.

If I can be all in below $90k for a house with a rent of $1600, then I would be look at the details,

In the Dallas area you won't find that relationship between price and rent unless your in a C- area

Originally posted by @Bob Bowling:

Please give an example how you ACTUALLY do this and I will show you how it doesn't work.  Rough figures are OK.

Sure.  Many turnkey providers do this.

Here's an example: http://lawsonwealth.com/3522-garden/

I've also seen spreadsheets for cap rates that account for SFRs (heck, even condos).  Very curious to learn what doesn't work about it as that's how I've started evaluating certain deals.

Thanks for your input.

Avi

That's for all of the input. I'm curious about the cap rate discussion, especially considering all of the public ally traded SFR REITS use it as a metric. It seems like a valid metric to me given the circumstance.

4 bed
2 bath
1800 sq ft
Finished basement
Updated kitchen

The home is in a good neighborhood and doesn't have much in the way of deferred
Maintinence, though in sure it will come up. It's rented to college kids.

Originally posted by @Avi M.:

Sure.  Many turnkey providers do this.

Here's an example: http://lawsonwealth.com/3522-garden/

  I've started evaluating certain deals.

Thanks for your input.

Avi

That's exactly what these people WANT you to do because they are trying to sell you crap based on a flawed analysis.  You've heard the term "cap rate" thrown around and think that NUMBER means something so if someone shows you a 19.7% cap rate they want you to get all wet about the "deal" when an experienced investor sees "Danger!  Will Robinson, Danger!  In commercial property investing buyers DO NOT compute a cap rate on the property they are considering.  So why would you utilize cap rates differently on any property type? 

I believe Steve posts here. Let's ask him for an explanation of why he is posting a cap rate on a SFR for sale.

Yes, you can calculate a cap rate on a SFR or a condo but you are wasting your time because there is no way to use it!

@Bob Bowling 

I still don't quite understand the logic behind your reasoning.  Granted, I'm somewhat of a new investor, but bear with me.

The value of a cap rate to me is two-fold.  One, it allows for an apples-to-apples comparison of like properties.  Two, it tells me, as an investor, the net proceeds in relation to the asset cost (whatever that asset may be).

Seems like a simple equation and I'm a fairly logical person.  I still don't see the flaw in providing cap rates.  On the flip side, how else would one numerically evaluate properties if not for a formula much like the one devised for calculating cap rates?  You surely would have to include the building cost, operating costs and income into some equation.

Originally posted by @Avi M.:

@Bob Bowling 

The value of a cap rate to me is two-fold.  One, it allows for an apples-to-apples comparison of like properties.  

If you want an apples to apples comparison of SFR's use the comparative market approach. Way less math and about 100 times more accurate. That is EXACTLY how an investor would do it if there were two similar vacant properties AND one had just sold.

How can you argue against that?

Originally posted by @Avi M.:

@Bob Bowling 

  Two, it tells me, as an investor, the net proceeds in relation to the asset cost (whatever that asset may be). 

 

"net proceeds"?  Can you define? 

Bob, I understand what your getting at that 1-4 unit properties are valued based on comparable properties not on there income production.

So the best way of determining value of those assets would be by comps, and that is how an appraiser will determine a value. But I still have to agree with some others on here that it is a worth while metric to use in comparing how much your purchasing a property for versus how much it will rent and produce. Based on your bio it would seem you have bought and sold many properties over the years, did you never use cap rates, NIO, ROI or other metrics to evaluate?

And good article!

On the CAP rate discussion: Personally I like to look at the Cash-on-Cash return. If I place x in to purchasing a property what rate of return will I get on my cash? Property B may cost less but if I can buy Property A with zero down and $10,000 in repair and make 12% I'm happy. To me it depends on your goal. I want long time cash flow so I can relax one day ????

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Originally posted by @Nick Fitzpatrick:

 . But I still have to agree with some others on here that it is a worth while metric to use in comparing how much your purchasing a property for versus how much it will rent and produce. 

And good article!

If you want a ratio of price to rents just use a GRM. Very simple to use and not all the GUESSTIMATES that you have to use trying to figure a cap rate. You look at similar buildings THAT HAVE SOLD. They should have similar rents and expenses if they are comparable. Divide the ACTUAL sales price by the estimated rents and you have a VALID GRM. Now figure your gross rents and multiply by the GRM and you have a market value. How easy and much more accurate is that? If you tried to value by a cap rate where would you get ACCURATE cap rate comps?

RULE of CAP RATES. A cap rate comp is the result of an actual sale. You take the accurate information from that sale and others that are comparable to your property and divide your potential NOI by the cap rate comp number that is most comparable to your property. That will give you a market value for your property. If you or someone else then closes on that property then YOUR property will become a cap rate comp for other properties. Figuring a cap rate using the subjects NOI to an anticipated purchase price for that property gives you nothing! How can it be comparable, it's the same?!

As for myself I use valuations that are appropriate for the property type and for my goals. ROE and IRR, etc will tell me more about the PROFITABILITY of a property. Comps (for under 4 units) and cap rates for commercial and multi's will tell me what the market is paying for the property or the NOI at that time.

@Bob Bowling Great info.  Thank you for taking the time to fully elaborate.

@Nick Fitzpatrick  @Zoran M.  @Avi M.  @Brian Sealey @Jeff Valentino  @Bob Bowling @Andy Collins  

Guys, I agree with Bob's comment about the cap rate not being the right approach for single family residences. Investors can more easily derive valuations for SFRs by using a comparable market approach generally based upon "like" properties in the same neighborhood. Bottom line: SFRs have a great deal of homogeneity to them.

Conversely, cap rates come in much more useful given the heterogeneity found in larger multi-family properties, as well as other commercial properties. It enables us to compare 15-unit MF to a 24-unit MF in a market where market comparables simply don't exist. Hope this helps.

@Zoran M.  , I've analyzed the deal using my Cashflow Analyzer. Why put $500 for utilities when you said the tenants are paying for all the utilities? I agree with @Jeff Valentino  about factoring in property management at 10%. I also factor in 10% vacancy. Below is the screenshot of the Cashflow Analyzer. Just based on the numbers, it seems to be a good deal...in fact, it's an awesome deal. But as I said in my podcast, real estate investing is NOT just about the numbers. I bought a 36-unit building once based on the numbers but it was the worst deal of my 10-year investing career. Here's the link to my podcast:

http://www.biggerpockets.com/renewsblog/2014/04/10...

Originally posted by @Wendell De Guzman:

. Just based on the numbers, it seems to be a good deal...in fact, it's an awesome deal. But as I said in my podcast, real estate investing is NOT just about the numbers. 

But there is a number that says this deal sucks! That would be the GRM. 4.3 !!! If there is not a valid reason that the market would only pay slightly over 4.3 times the gross rents then you have to say it is determined by the market that this is a bad deal.

Using cap rate is simply to determine your estimated return on investment or "cash on cash". I've never seen such a run of discussion about something that is nothing more than "numerator / denominator". Bob's argument for ROE / GRM / IRR is inapplicable to the posters point and question, and the idea that "comps = value" is absurd, as if my neighbors house is overpriced so therefore I am willing to pay the same price. Rather, that buyer will lose his shirt while I stand by and observe his demise. In accounting, ad particularly M&A we used IRR predominantly but for complicated asset pools with ever changing assumptions for projected time horizons. I can look at a $100k house, ceteris paribus, which generates $10k annual, where the renter pays all costs, roughly say "Im a gettin 10% cap rate". Now, is this "good"? That is a qualitative question from the perspective of the investor. If you have a load of 15% Cap investments on your plate (using the same metric) then you would never buy something with less cap; if you only have bank CD's available to you because of your "own" risk averse standpoint, then that is your sphere of investment in which you operate either because of preference or otherwise, and therefore a cap rate (again using the same metric) of 10% would be a premium in your portfolio. A GRM fails, where two units are compared and the expenses are disparate unless you still equalize expenses. This home purchase is contemplated on cash in pocket, if I can get $1,600 monthly on a $83k investment, then I have no intention on disposing of this asset and thus the interim flows will be well above market, and if I sell I will at least recover my investment plus appreciation having accumulated those cash flows. This ongoing discussion is a futile attempt predicated on the failed premise that "apples suck, because oranges task good".

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