Cap rate, pro forma cap rate, cash on cash ROI?

7 Replies

Though I’m not new to investing, I am new to formally analyzing deals. And...I don’t know what to look at anymore. When I run analyses, I don’t understand which figure to focus on to see if the investment is a good deal or not. Do I look at cap rate, pro forma cap rate, cash on cash ROI, or does it depend on what type of deal it is (i.e.: rental, flip, BRRR)? Or, in what scenarios/instances do each of these matter more or less? I’ve Googled what each means and I understand, but can’t seem to apply these concepts to my analyses. Thanks in advance!

@Aaron McCarty if you look at the formulas/metrics in isolation then the numbers don’t mean much.

The formulas/numbers is all relative, especially as everyone/business has different goals and risk tolerance.

Compare the results to the alternative, example: compare the historical stock market return on blue chips to an A class area. Caps rates (assuming no debt) are probably around 5%-8%. Whereas, your return on the alternative is 2-3%.

Same thing when comparing A class properties to C class. Determine how fast you want your money to grow and the time you want to hold your money in the investment (break even in years), relative to the risk of each. Then compare the numbers to decide which fits your goal more. Some people don’t mean a lower cap as the investment is usually the safest and the stock market return is lower. On the other side some people don’t mind the risk for a much higher turn of their money.

Define goals for your money. Then find a property/investment which meets or exceeds that goal.

I’ll add piggyback onto @Aaron McCarty ’s question... what’s the difference between pro forma Cap rate and Cap rate? 

P.S. Bald Guy Properties is a phenomenal name 😂😂😂

I think these are great questions and I wrestled with it for a while until I just finally got over it by realizing what I wanted.

1. A cash on cash return rate higher than that of index funds which I could get and be 100% passive.

2. Cash flow that got me excited, relative to the rate of coc return.

For example l: coc return of 12-15%, the cash flow needs to be a few hundred bucks vs a coc of $100-150 door, that coc return better be 15%+ to make it it worth only getting $150 or less.

The only other piece that I’m weighing as I hunt for my next deal are exit strategies. If I can’t get out of it easily, it needs to cash flow more and get the higher end of coc return on the ranges mentioned above.

Investing is personal. Read/consume, but eventually you have to make a decision and stick to it. Be open minded but be very convinced if strategy is going to change.

Good advice above. If I were in your shoes, I'd take a step back and before I worried about how to analyze a property, I'd decide what my investment goals are, which will heavily inform the way you analyze a property. For instance, I want significant positive cash flow. Some people only want a safe place to park their cash. Some people want a high CoC return. Some people will be fine with negative cash flow and bank on appreciation. You probably have already thought about this and may already know, but it's tough to help you determine your criteria when we don't know what it is you are trying to achieve.

On a side note, cap rate is usually used in the analyzing of commercial properties. There are several people here who like to use it for residential properties, but I don't believe it's a great indicator of value for residential, especially SFH and duplexes.

Good luck out there! 

@Aaron McCarty , "pro forma figures" tend to be what the Seller provides you. Think of them like what a used car salesperson would tell you about their car for sale. [Exaggerate much?]

ie. You'll be better served by being more conservative in your analysis. (ie. Calculate that expenses are likely to be higher, revenue likely to be lower).

Value for 1-4plexes is largely determined by sold comps, not by commercial market cap rate. Of course, you should always offer significantly less than those sold comps! All the best...

It looks like my wife has been impersonating me again but I am so glad she asked these questions. Everyone has been very helpful. We currently live and invest in Wichita KS and appreciation is slow and steady so we look mostly for high cash flow. We mainly look for a monthly cash flow of $250 or higher with a CoC return of 12% or better but we do deviate if one is substantially high while the other metric is lower. The "Pro Forma Cap Rate" and the "Purchase Cap Rate" we don't have a good feel for what the numbers should be. Thanks everyone for the insights.

The “pro forma cap rate” for commercial properties will most often be created using what the potential rents could be rather than what they are. When purchasing you should never pay on what the rents could be but rather on what they are. You will need to do your own due diligence when figuring income and expenses and should get what is expected off of that.

In Wichita we haven’t had a commercial information exchange (CIE - the commercial version of an MLS) so loopnet and broker to broker info exchange is how business has been done. Thankfully, the local realtors associate voted to create a CIE and we will be getting one next month. This will now make it much easier for agents and brokers to share and maintain information so cap rates in the area will become more transparent to realtors.

As of right now your best bet on getting cap rates for particular property types is by contacting commercial brokers or commercial lenders.

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