What is your criteria for classifying a deal?

Question

I see a lot of advice about how it's not important to hit a home run with every deal.  String after string of single and double deals with score lots of runs and success over time.

In terms of cap rate and COC return on a  a particular deal (considering the market you invest in and your goals) what ranges would you classify as an single, double, home fun or strike out (hopefully avoiding these completely).

I know some investors are happy with a 6% cap rate while others won't touch a deal unless they think they can do 10% or higher so if you want  to qualify why you set your range how you do that would be great too.

Ben Leybovich · Answer

Keith J.  This is a thoughtful question.

RE has 2 speeds: Forward is usually slow; Reverse is fast and painful.

With this in mind, the most basic goal of any seasoned investor is NOT TO LOSE.  Well – what does it take not to lose relative to long-term CF assets?  The answer is healthy CF.  One’s ability to hang on to the asset long enough to weather the storms that may (usually do) come is plenty of CF.  This would lead us to believe that the Cash on Cash is the most important metric to consider – as others have suggested.  But, let me throw a curve ball at you – to stay with baseball:

Last Monday I closed on a 10-unit.  The purchase price was $373,500.  The CAP rate was 11%.  I put down $5,200 into the deal (2%), while 98% was financed, and still I am showing $12,000 of annual CF.  In this case the Cash on Cash is 240%.
Now, most people would have put down 25% on a deal like this ($93,375).  In doing so, they would have saved on their mortgage payment(s) about $800/month simply due to a lower mortgage amount.  Thus, their CF would have increased by $9,600 per year – a very significant amount.  However, the Cash on Cash return in this case will have been:

COC = $21,600 / $93,375 = 24%

Thus, if we were to look at the CF number only, then obviously $21,600 is better than $12,000.  However, I think most people would agree that 240% COC return is better than 24%.  But regardless, the CAP rate is 11% any way you slice it.

This is a “comfort level” question, and a philosophical question.  Personally, if I am able to achieve “healthy” CF while leveraged 100% or close to it, I will do the deal.  I won’t "kill" on the CF, but I’ll do well enough and I can do it with little or no cash in the deal, which in my book is a great bonus.

For a lot of people this becomes a question of “a slice of pie is better than no desert”.  If you have little money to play with, then this is a good way to look at it.
Finally, my measuring stick is ALWAYS the NOI and CAP rate.  I know that with a CAP of 10% I should be OK, a CAP of 11% I should be good, and a cap above 11% I should be great.  From there it becomes a question of cost of money.  Hope this helps.

Ken C. · Answer

Keith -  I think you answer lies between 5% and 10% depending on your market, time to invest in managing the property, tenant risk and location.

I am a buy and hold multifamily investor. I have a full time job and invest for retirement. I am do not have time to manage or oversee  renovations of properties. Nor do I have time to invest in properties outside my local area that require me to visit frequently. I look for fully rented low maintenance renovated properties in a higher rent/high demand  area.

Having said that, for me a 6% cap rate is a single, a double or triple is 7-8% and a home run in 9-10%. As interest rates rise, so should your caps rate min. My banker says 5-8% is good for my area based on his multifamily loans. I also use a proforma cash flow statement, COC return, after tax return ROI and price per square foot to screen best selection. You can find software to do all of this for you cheap.

I haven't hit a home run yet, but have 2 double and a single over the last 2 years.

Good luck

Ken

Keith Jablonowski · Answer

Thanks Carl, I meant to state I was looking for replies from buy/hold investors mainly.  I do know this is all subjective and that's the interesting part of my question.  Want to see what it is for each individual that makes a deal one to walk away from or one that is a home run.

I suspect there will be a very large range of numbers even from investors in similar types of properties.

Carl Schmitt · Answer

Wouldn't it depend on the type of investment?  Someone who fixes and flips isn't going to be happy with the same returns as someone who buys and holds.  Even in the same category of investing, it would change. Someone who buys in a really nice suburb that has a manager in place isn't going to expect the same return as the guy who self manages a duplex in a war zone somewhere. What type of investing do you plan to do?

I don't own any yet, but when I look at properties and decide if its a good investment, I like to look at the rent to purchase price ratio.  It's not the system I would use to actually purchase, but I like it for doing quick numbers.  Once you know the market, you know what a certain unit will rent for, and you know roughly what the purchase price per unit should be in that area. In the same town, taxes should be similar, and insurance costs as well.  I think you can determine fairly quickly if it even makes sense to look closer.

Omar Rivera · Answer

Totally agree with Bill Gulley's comments.  CAP rate is a good first-pass litmus test to see if its worth further looking into.  Quick calculations like that are useful to create a shortlist and then gather more detailed information to build a cashflow pro-forma over your investment horizon.  I personally like to use an NPV analysis as it will tell me how much I can invest and what my B/E will be between selling or keeping it as a rental if the property ever increases in value.

Don't get stuck on any particular metric or value (10% or 15% or whatever).  I suggest you get used to looking at EVERYTHING in your target market, filtering with a quick metric like CAP rate and then just looking at the best opportunities, whatever they may be.

Bill Gulley · Answer

I would generally look at 15% due to taxes, but I rarely considered a cap rate as it is difficult to ascetain by definition long term and while you may go into a deal with a number as a target, it will usually be wrong. Cost of money and use of funds play here and that is not constant.

I see cash on cash returns, return on investment after taxes as a better yard stick to past performance and that historically guides you to new deals, what you should hit to increase your business.

Frankly, I didn't have much time to sit and play, like Midas running his fingers through gold coins, it's interesting to push numbers, if you enjoy what if's and analysis, but that isn't making money!

I had to see at least 5k in a deal within 3 months to mess with it, didn't matter what is was and more if it would be more time consuming or drag out longer.

Capitalization rates need economic values to be realistic and attempting to figure out opportunity costs may be impossible for small investors or deals, takes more time than it's worth.

So, I rarely consider a cap rate in the true sence as a determining factor. I/m a finance guy and it's easier just to watch your deposits accounts grow that figuring out the rate of growth, you can see quickly how you are doing at the end of each month!

Wear those buttons out on your calculator....LOL   :)