What is a good roi??

Question

James C. · Answer

Laramie,

Warning: Long, Dense, Theoretical - take with a glass of your favorite beverage:

Things to keep in mind, from Business 101

Definitions:

**I am going to use CAP rate as a proxy for ROI**

Value: One way to calculate the value of any asset is the sum of all the projected free cash flows (NOI) discounted at the weighted average cost of capital (Interest Rate or CAP rate, depending).

Risk Free Rate: The interest rate for a deal that carries no risk of loss of money. Example: 30 Year Treasury bond rate.

Risk Premium: The markup on the risk free rate to account for the risk of the investment.

Generally, I would look at the lender risk premium as the quoted interest rate for the deal minus the 30 year bond rate... so, the riskier the deal, the higher the interest rate (Lender), and the higher the required return (Borrower). The Borrower is looking at the quoted interest rate (or it's proxy, the monthly P&I payment) plus the Borrower's risk rate. They are the same idea, just from different perspective.

Now, lets apply this to your situation.

Generally, cash flow oriented buyers are arbitraging the difference between the cost of capital and the free cash flow generated by the asset, then discounting that to arrive at a value. Remembering that the lender is arbitraging the difference between their cost of capital and their lending rate. The more risk, the more the spread (we are of course talking about perfect markets, lack of greed etc.), and the higher the return (CAP rate) must be.

This all leads us to what is a good CAP rate:

A good CAP must be judged based on:

Class of property: an "A" class property carries less risk of default than a "D" class property, therefore, the CAP rate can be lower.

Size of building: For any given asset class, a larger building carries the lower risk of default, since the FCF is supported by more units. This is one reason why a 6 to 10 unit building has a higher CAP rate than say a 50 unit building, more risk (i.e. cost spread over fewer units in the 6-10 vs the 50).

The cost of capital: Since the Cash Flow orientation is an arbitrage, it would stand to reason that the more you are going to pay out, the more you need (or want) to make (it's another proxy for the risk).

Experience: The more experienced investor, the better understanding of risk in the marketplace... this is why BP (and everyone else) pushes having a mentor, reading, understanding, collaborating etc. A really good investor can "see" things a less experienced investor misses, hence lowered risk. Experience allows you to arbitrage the deal better. This is why having a mentor when just starting out (or switching asset classes) is so important. Even more important is listening to them.

Business model: Some business models would take a lower CAP rate for a given asset class in exchange for some other factor. Example: if you have the only rental in a town, and there are no more houses being built there (Dumb example, I know). If that is the case... even if it's a C class property, it could make sense to have an "A" class CAP rate.

With all that being said, your CAP rate is whatever makes sense for your location, business plan, asset quality, lender tolerance, experience, cost of capital, etc. I would do an internet search  for "Property Class and Cap Rate" and read a few of the results to get a feel for what others are saying, then consult your mentor, and business plan (tip, if you don't have either, probably best to get them sooner rather than later).

Let me know if any of this is unclear (Yes... I have substituted ROI and CAP, hopefully not incorrectly), or if you need more information.

Thank you,

Jim

Joe Splitrock · Answer

@Laramie Hiebner consider risk versus reward. If you invest in a whole market stock index fund, you will average over 9% annual return with no effort at all. Of course real estate has other benefits and ROI is not the only measure.

We really need more details to determine if this is a good deal for you:

Purchase price

Down payment

Financed amount / interest rate / term / monthly payment

Monthly rents

Class of property, A/B/C/D