Originally posted by @Bram Spiero:
@Ben Leybovich You are right to insist that @Mark Albano use an analysis tool to help him decide if to go with a deal or not. That's not enough though. Just because you can now calculate NOI, Cap Rate and ROI doesn't mean you understand what these numbers mean. It is this understanding which will allow you to discover what your highest offer for a property should be in order for it to give you the returns you require. I even think that doing enough analysis will help you to better understand what it is that you require.
Bram, sounds like you might have some formal training in the matter.
Not picking at you, but you say you need to understand what the ratios mean, what measurement you're actually looking at. So, lets pick one, the cap rate.
Cap is short for capitalization rate, to arrive at a valid cap rate you need to compare the rate to alternative investments to make a decision;
Picking a random ROI, say I just pulled 22% out of thin air, my investment requirement is to hit 22% or I pass on the deal. Then, I'm looking for a 22% cap rate after taxes, we all know I won't be buying many properties.
For your cap rate, you have inside of that a "managers rate of return" or the "Internal rate of return" arriving at that, bringing each dollar received in the future back to its present value, the beginning rate selected is that expected in the market compared to other investments requiring similar risk, costs of management and administrative expenses as well as tax treatments. So, what is that alternative investment to real estate? Most often it needs to be another real estate opportunity.
If I were to select bonds or stocks or insurance annuities as my alternative investment, then to have an apples to apples analysis I must consider the risks involved, mgt. required, admin. and market fluctuations and then adjust these factors to mirror those applicable to real estate.
Remember too, that $132 cash received clear on your opportunity investment, it goes through the similar analysis, that sum is reinvested for the best use of cash, otherwise you have a skewed view of the value of that annuity stream, what those payments are really worth. I can tell you (everyone) that trying to figure this aspect is impractical, as I mentioned the differences of option A and option B might be a hamburger at lunch. Alternative investments are very limited (keeping with liquidity considerations) for $132 a month. And, don't forget to bring the salvage or residual vale in the future back to its present value.
I'm addressing an economic cap rate, a financial cap rate, not simply investment/income as that is to accounting, not to investing.
For the 147th time, real estate is unique, it can not be directly compared to stocks or bonds or annuities or the manufacture of widgets. Because RE is unique you comparable investments need to begin as other RE opportunities. So, now, you're looking at other RE similar to the subject, if you don't own other similar properties you'll find it hard pressed to obtain a real cap rate on a pro forma basis or estimating future performance.
Doesn't take long to figure out, if you're doing things properly, that you're running in circles chasing your tail!
So, in your buy decision, trying to assess ROI, a true cap rate or a valuation of cash flow is pretty fruitless.
Now, after the purchase, you have historical numbers and you can then calculate actual ratios, that can be valid.
I admit, I learned the hard way, being a finance/accounting/economics type, I went through the same thing other students of RE do, trying to apply other business practices in this matter to RE investing. I may have come to the realization of this reality since I taught the subjects mentioned, it became obvious that accurate numbers weren't possible and the reason boiled down to the uniqueness of real estate, it's a different animal as to investing. In terms of investing, RE is closer to speculation due to the unknowns to be faced in the future. I can tell you what you're going to be getting on a AA rated bond, I can't tell you what your RE investment will be a year or 5 years from now.
Ben summed it up, numbers don't mean anything in reality, except ensuring that your horse isn't eating all the hay before you buy him. Trying to figure out how fast that horse will be is delusional and wishful thinking. Those formally trained in F&A are forgetting chapter one, use appropriate analysis required that pertains to the size, scope and type of investment or business. Wall Street is compared to Wall Street, RE is compared to RE, Insurance is compared to insurance, CDs to CDs, makes life easier and more valid in reality.
Yet, some will continue to run the batteries down in their calculator, projecting their expected wealth. Don't worry about it, work hard, work smart, go forward and it will happen. :)