Use cash flow not CAP
What is this 25% expenses number?
I use purchase price, down payment (which is 25%), water/sewer, PM, 10% for vacancy and 10% for Maintenace. You also have to take into consideration they are buying a unit with low rents and they intend to increase the rents and increase the cap rate or cash flow that way. I am buying a 5 unit with a terrible cap rate but I know once I get all the rents increased they cap rate will almost double.
To clarify, that 25% was in addition to the purchase price and down payment of 25%. Sounds like my expenses are too low anyway. I hadn’t considered water/sewer which seems pretty obvious now.
I guess that, being green as I am, I’ve been hesitant to go after a property based on potential income and have been looking for properties that cash flow right away but have potential to add value (bedrooms, etc.).
But hey, better to learn it here than the hard way right? I certainly appreciate the feedback.
Do you use any rules of thumb to tell if a property is worth looking at?
@Rob Gervais That's kind of a broad question. I'd suggest you start running properties through the BiggerPockets calculator and get used to analyzing them. I'd use Jake's number - 10% management 10% vacancy and 10% maintenance. Those are pretty common numbers and safe. Water and sewer you'll have to figure out, some properties list numbers, not that they are guaranteed accurate but ballpark it. And don't go low to make the numbers work. Do that enough times and you'll soon be able to quickly get an idea whether a property has potential, numbers wise at least.
Then of course you want to look at location and make sure you're buying in right area.
Best of luck. GR is a great market but has been on fire for a while now.
It's probably fairly common to see low, real low cap rate on residential properties (1 to 4 unit), especially in a hot, low supply, high demand market. Within residential properties which are 1 to 4 unit properties, not only are you competing with other investors you're also competing with owner occupants (i.e. for these buyers success/failure calculation is not the same as that of investors). A 2% cap duplex in an excellent school district is a success to an owner occupant but not so much to an investor (i.e. 2% cap is tough to finance and still cash flow).
Cap rate is more commonly used in analysis and valuation of 5+ unit properties. Within this market segment, you're typically competing with investors only so the success/failure calculation is the same for all potential buyers (i.e. everyone is all on the same level of playing field, everyone is looking for cash flow).
To answer your question - is it the metrics? or are people setting themselves up for failure? It's more likely the metrics you are using. Cap rate has little relevance in the analysis of 1 to 4 residential properties, it is particularly irrelevant in valuation of those properties (i.e. "comps" are used instead)
So cap rate is definitely commonly used in analyzing 5+ units but other metrics such as CoC and/or IRR are typically more useful in analyzing 1 to 4 units. Better yet why not use CoC and IRR on all types of real estate properties? ...... Or bonds, or stocks, or bitcoin, or crude oil.... you name it.
That makes a lot of sense. Thank you!
Hey @Rob Gervais -- I agree with the posters above that cap rate is probably not the BEST way to analyze a duplex, but it's also not a terrible way to do it either... I think you might have an error somewhere in how you're calculating your cap rates which is skewing your numbers.
If you're using an expense rate of 25% like you said I'm not sure how you could be getting a 3% cap rate... You should be getting cap rates way higher than that. I'm an full-time Realtor & Investor in Grand Rapids in both SF & MF and most of the duplexes here have been going for somewhere close to the 1% rule. (btw, the 1% rule is: $150k renting for $1,500/mo... or $120k duplexes renting for $1200, etc.)
So, if you find a duplex around the 1% rule, and if you're using a 25% expense rate, you should be getting a 9% cap. For example:
- Let's say a $150k duplex brings in $1,500/mo in rent.
- That's $18,000 per year in gross rents.
- 25% in total expenses = $4,500
- That's $13,500 in NOI (Net Operating Income)
- Cap Rate = $13,500 / $150,000 = 9%
Actively listed right now in Grand Rapids there's a duplex at 142 Carrier Street NE renting at $600/ea ($1,200 total) listed for $130,000, and there's another at 649 Easter Ave SE that should get $750/ea ($1,500 total) listed for $145k.
**Last thing I'll say is be careful because I think estimating 25% in total expenses is light. You have to analyze it deal by deal to know for certain, but if you're going to be using a rule of thumb I'd be more inclined to use something closer to 50% instead of 25% for my total expenses. If you do that, you'll be seeing 1% deals come in at a 6% cap rate.
Rob, I would use a 55% expense ratio on a 2-4 unit property here in GR in this market. Things are selling at around a 7-8 cap on this stuff typically, occasionally lower or higher. You are forgetting taxes & insurance in there, lawn care, plowing. 1% rule is too tight here in my opinion, I'd go for 1.4%.
PM me if you have any other specifics or want me to analyze a deal you are serious about.
Hi David. I think where I was going wrong was that I was using Net Income as opposed to NOI. The 25%, while still too low, was in addition to taxes, insurance, and debt service.
@Rob Gervais I would use actual numbers instead of expense ratios because those are catchalls but you can't tell me that a home built in 1950s with vinyl siding has the same capex as a home built in the 90s that is brick and 10% of rents works for both. In reality older homes generally get lower rent and more capex. At a high level I will use that to screen a deal but in general I'd look at the major expenses that need to be repaired in the next 5 years and expense that over 60 months to get a more accurate capex. If you do it enough you will make better assumptions than percentages. Also, consider valuing your time return as much as your actual percent return. I can buy all day in city of grand rapids houses with a panoramic view of the Oak Hill cemetary, and in theory have a high percentage return on investment. But I would make 2k a year or i can buy newer homes with less headache and make 5-8k a year with less time invested on repairs and problem tenants. 10% CAP sounds awesome house but if its a 60k house its not worth most peoples time when you look at how much you make hourly to manage it.
That's solid advice @Charles Kao , thank you. Truth be told, I don't own anything newer than 1900 so I have yet to enjoy the joys of low capex.
@Rob Gervais I am a bit late to this thread but curious how things are coming along. Also, I think 5% is on the high side for vacancy rates in the GR area. I currently have 4 SFR's and a duplex and my vacancy rates are closer to 2%.
@Ryan Kuja I ended up finding a FSBO duplex that covers the mortgage and expenses and puts a few dollars in my pocket. It's a C property in a B+ area with space to add a bedroom and a half bath in one of the units. I needed to find something that cash flowed off the bat so I could build some reserves for the reno and everyone in this thread was immensely helpful.
I ended up using 50% expenses and looking for at least $100/door as my metric.
It's funny how much you can learn in such a short period of time. Thanks, everyone!
More downpayment, cash flow matters. In all honesty people in CA still get 5-6% cap in California with upside potential. In urban coast neighborhoods like SFO, SJC with stellar rental income investors will still consider 3% cap and cash flow with 13-20% annual appreciation often they pay all cash.
Hey @Rob Gervais , my business partners and I are putting in our first offer on a property in Grand Rapids. This will be our second duplex, but first out of state and in GR. How is everything working for you? Have you gone on to purchase another property since then?