Cap Rate/CoC Return

23 Replies

I'm fairly new, but looking at a possible 4-plex with a partner.  In an all cash purchase/reno, shouldn't the Cap Rate and Cash on Cash return be the same?

The only time CoC should be different is when there is a loan...correct?

Thanks!

Rob

All other inputs being equal into the two calculations...."Yes".

The property itself will have a Capitalization Rate and the investment, if you will, will have a Cash on Cash return.  

To speculate based on your post, perhaps the manner in which you are capitalizing and calculating the renovations is the issue that offsetting the two numbers.  

Hi @Dion DePaoli  -

Thanks for the response.  I was actually getting the same number for both and started thinking about it.  I thought in this scenario they should be the same, but didn't want to miss something.

Originally posted by @Rob Scarborough:

I'm fairly new, but looking at a possible 4-plex with a partner.  In an all cash purchase/reno, shouldn't the Cap Rate and Cash on Cash return be the same?

The only time CoC should be different is when there is a loan...correct?

Thanks!

Rob

Why would you care about a cap rate on a fourplex?  Where do you plan to get reliable cap rate comps from? 

@Bob Bowling - So is cap rate for commercial property only?

Originally posted by @Rob Scarborough:

@Bob Bowling - So is cap rate for commercial property only?

 Cap rates are only usefull for property types where you can get reliable cap rate comps.  99% of small residential owners don't keep records accurate enough to be comparable and they would also not compute consistently the same way to have valid meaning.

Yes, I use CAP rates because it lets me analyze my houses all in the same lense.

@Bob Bowling If you are not using a cap rate to value a property.  How do you come up with your offer price?  Cash flow preferences?

Originally posted by @Elizabeth C.:

Yes, I use CAP rates because it lets me analyze my houses all in the same lense.

You can do that easier and more accurately using a GRM or a CMA.

Originally posted by @Ryan Lockstein:

@Bob Bowling If you are not using a cap rate to value a property.  How do you come up with your offer price?  Cash flow preferences?

The ONLY correct way to value a property using direct capitalization is to get current cap rate comps from market SALES. Then you take the NOI from the property you want to buy and divide it by the MARKET cap rate. That tells you how much the market is actually paying for that amount of NOI.

You can do that easier and more accurately using a GRM or a CMA.

Could you explain?

@Bob Bowling - my last post didn't tag you...

Sales prices are pretty easy to get. Rents of similar properties (residential) should be within a small range. If you know the purchase price of three similar fourplexes and know the approximate market rents you can multiply annual rents by 4 and divide the sales price by that number. The range should be small , say fourplexes are selling for 9-11 tlmes the gross rents. Those numbers times your rents gives you a good idea of market value without all the errors of three investors computing NOI differently.

Even if you found three investors that computed NOI correctly and completely consistant with each other WHERE would you find that information?

CMA'S need sales and building information AND a reasonal amount of knowledge of the market to make accurate adjustments. A realtor or active market participants can do this.

The answer to your question: "Yes" ... In an all cash deal, cash on cash return before taxes will be equal to CAP.

I utilize a CAP rate analysis for all of my transactions whether a SFD, duplex, 4-plex, or apartment building so that I can compare the investment as a whole on the same playing field. Of course, COC return is very important and must also be respected... assuming a positive cash flow, property leveraged at 100% (not advised of course) has an almost infinite return, whereas, if you pay cash for the same property you now have a limited returned, albeit more realistic, return.

To value purchase price of property, I compare GRM (much easier to derive) and along with my internally calculated CAP for the property. You can always request a break down of seller's NOI... Very few will be able to back up, with logic, how they get to that number but you can make educated guesses yourself on most of it once you have done a few.

More than you wanted, but hopefully you find this useful!

To answer your original question. Cap rate is the ConC return on investment if you pay all cash.  This is basically what everyone else has said. 

I can not disagree more strongly with @Bob Bowling   Of course you can use cap rate to evaluate a 4 unit or less building. While appraisers and banks may not use cap rate and prefer the comparable sales approach there is no rational reason for doing so. The cutoff between calling a 5 unit+ building "commercial" as to distinguish it from a 1-4 unit is an arbitrary distinction and has no place in evaluating the investment for your own purposes.

Because appraisers and banks use the comparable sales approach for 1-4 units then it becomes important only to the degree it helps or hinders your ability to get financing.

Maybe Bob and I agree after all

What Bob is describing is how to find a market value for a property.  His comments make more sense in that context. 

However when I evaluate a property or a deal I don't care what the market says it is worth, I only care what it is worth to me! I want to know the cap rate. Of course cap rate is only one small part of my evaluation. Cash on Cash is important, Debt coverage ratio, condition of property, neighborhood, rents relative to market, IRR, LTV, GRM, etc.

The "Market" is not a very good judge or value. If it was we wouldn't have market cycles. In 2006-2007 when the risk of the market was high. The "market" was willing to pay high prices.  In 2009-2010 when prices had plunged the risk of the market had greatly decreased . Yet the "Market" greatly undervalued properties in that period.

Originally posted by @Ned Carey:

I can not disagree more strongly with @Bob Bowling   Of course you can use cap rate to evaluate a 4 unit or less building. While appraisers and banks may not use cap rate and prefer the comparable sales approach there is no rational reason for doing so. 

@Ned Carey The rational reason to NOT use cap rates for SFR's and really any multi probably under 25 units is that there is no reliable database of cap rate comps for those types of properties.

Bob,

I guess I didn't make my point clear. I don't care about a "Comp" I want to evaluate the performance of the property. Cap Rate is one way to do that.  

I don't want to compare that cap rate to other properties. I want to compare it to my expectations of an investment.

Originally posted by @Ned Carey:

Bob,

I guess I didn't make my point clear. I don't care about a "Comp" I want to evaluate the performance of the property. Cap Rate is one way to do that.  

I don't want to compare that cap rate to other properties. I want to compare it to my expectations of an investment.

I would encourage anyone to look at NOI for any property. But I wonder HOW you evaluate performance using JUST a cap rate? I think you can only come to some conclusion because of your experience.

So on your property you use YOUR purchase property against YOUR NOI. That gives you a percent. So if you say "Hey, I've got a ten cap!" How would anyone know if that was good or bad? If anything a better metric would be measuring NOI over time. If you can say my NOI has increased 25% that means something to anyone.

I don't care about market CAP rates. That's a fiction purported by real estate brokers. The Capitalization Rate (CAP) and the Cash on Cash Return (CCR) are derived from the cost and structure of financing. Financing can be one or more tranches, each having a required yield. The weighted average of the tranche yields calculates the required CAP rate.

I explain this in detail in my article at

http://bit.ly/18tE68H

You can also watch my YouTube video at

https://www.youtube.com/watch?v=N_vRDWYT2gE

When you know the cost and structure of your available financing, then you can calculate the required CAP rate. Divide the Net Operating Income (NOI) by the calculated CAP rate, and that's what the property can afford to pay for itself.

Originally posted by @Jeffrey Smith:

I don't care about market CAP rates. That's a fiction purported by real estate brokers. The Capitalization Rate (CAP) and the Cash on Cash Return (CCR) are derived from the cost and structure of financing. Financing can be one or more tranches, each having a required yield. The weighted average of the tranche yields calculates the required CAP rate.

I explain this in detail in my article at

http://bit.ly/18tE68H

You can also watch my YouTube video at

https://www.youtube.com/watch?v=N_vRDWYT2gE

When you know the cost and structure of your available financing, then you can calculate the required CAP rate. Divide the Net Operating Income (NOI) by the calculated CAP rate, and that's what the property can afford to pay for itself.

Direct capitalization excludes financing.  What does  "the cost and structure of your available financing"  have to do with direct cap? 

sounds like you are expounding on this    

http://www.ccim.com/cire-magazine/articles/323227/2013/09/cap-rate-calculations-today

Reasonable when market caps (sales) are not available but not a good substitute when they are. Can you explain your meaning better?

                            

Thanks to all who have responded.  

On a personal and unimportant note: this is my post that went to the 2nd page - lol!

Originally posted by @Ned Carey:

The "Market" is not a very good judge or value. If it was we wouldn't have market cycles. In 2006-2007 when the risk of the market was high. The "market" was willing to pay high prices.  In 2009-2010 when prices had plunged the risk of the market had greatly decreased . Yet the "Market" greatly undervalued properties in that period.

 By definition the "Market" is the best judge of market value.  I don't understand how anyone operates by ignoring market value.  That's how you understand where the market is in its cycle. I would not shy away from paying over market if there wasn't a market substitute and I had plans that worked for that property but why pay over market just because you don't know what market is?

as defined here, your cap rate and ConC  are the same with no financing.

but I would note ConC and even 'roi' are very simplistic metrics. The problem I have with both is they don't take account of your WACC - weighted cost of capital. 

For example. In my case I have a portfolio of passive investments that generate returns, so any RE deal needs to more than beat my planned portfolio return, after tax. if it doesn't,  I'm better offkeeping the moneyin the portfolio. 

This is my I prefer different metrics in addition to ROI. I especially like NPV(@ wacc) / PV Capital investment, called the Value Investment Ratio.