Throughout the lifespan of an investor, as we learn and mature, the methodology behind our analysis of investment opportunities changes. Have you noticed this yet?
Personally, even before I knew anything, I never placed much emphasis on cash on cash analysis. I did not know exactly what it was that bothered me, much less was I able to formulate it on paper, but I sensed that a lot was missing in the CCR analysis, that it was faulty in some way. There is definitely room for it in our understanding of facts, but not in the way most people think. The same can be said about CAP Rates – they are important in some way, but not the way most think.
I have no intention in focusing this article on these metrics, but I must tell you that the problem with them in the most broad strokes is the fact that both are static in their nature. This is to say that they populate static data upon which to calculate themselves, and in this way they are more or less a “snapshot” in time. Notice, CAP Rate is not a metric of return at all, but rather a metric that tracks the marketplace…
Let Me Paint You a Picture
When you were in school, you received a grade card. This document looked back at your accomplishments in order to determine an average – the GPA. Then, in order to report to the State educational department, the school averaged the GPAs of all of the students in your class…
In this example, your GPA is akin to CCR – here’s the cash you invested, and here’s the cash you got out, and here’s the relationship of one to the other. And the average of all of the participants in the marketplace, which is the CAP Rate, is akin to averaging all of the GPAs of all of the students in your class. So, CCR is how well you’ve performed, and the CAP Rate is how well the market has performed.
Something to Note
Both of these metrics are forward-looking. They have to be, by definition, since it is only possible to average previous results. In order to try and extrapolate future performance from these numbers, we must discount them in anticipation of a whole lot of different things happening at some intervals with some percentage of likelihood.
Neither CCR nor CAP Rate do that, which is why, while I rely on both at certain junctures in the work flow of my underwriting, I do so for purposes other than projection of future ROI. And when I see people sell investment opportunities, either in the multifamily or turnkey SFR spaces, based on annualized CCR, I am not sure whether to laugh at the lack of sophistication of the operator, or cry at the stupidity of the investor in today’s marketplace. Though, considering the amateur hour that we are living through, nothing should be a surprise…
Why I Underwrite to IRR
I couldn’t sell an investment opportunity to any of my guys based on anything other than IRR. This is because they understand that in order to underwrite an IRR, I have to project and discount future cash flows, which means that I have to pencil with great specificity every single aspect of the movement of money in and out for the entire life of this investment.
And sophisticated investors, the only kind I care to work with, want me to do just that. Why? So that they can have a chance to trace my thinking and to issue a verdict. If they agree with the picture that my numbers paints, they put money in, and if not, there’s no deal.
Why I Will Pay Only What My Underwriting Allows Me
Think through this with me:
My underwriting says that I can afford to pay $4.1 million and project 15.4% IRR. My guys agree that this is attractive and are willing to fund the deal – they are willing to go if I can project at least 15% IRR.
Now, remember I wrote an article a while back in which I told you that CapEx is not a percentage, but rather a fixed cost? If you don’t, read here. Well, since I know what minimum IRR my investors want in order to fund the deal, I now have another fixed cost – the IRR to my investors. It’s not a fixed cost on paper since that would be illegal. But how many times do you think I could under-perform and still keep my career? So, unless people start being satisfied with lower returns than 15% IRR, I indeed view this as my fixed cost.
So, I know how much of the profit goes to my LPs, which means that the rest goes to me. If I pay more than my underwriting says I should, this difference must come out of MY pocket. I can’t take from the LPs’ pocket because they won’t trust my projections the next time around. I have to choose to work for less.
Folks, Listen Up!
I don’t care what Brandon says on his webinars, or what anybody else says — there’s not a single glamorous thing about this business! There are certainly honest people in this business, but to get to them we have to go through hundreds of liars and cheats! And it doesn’t matter if we are talking tenants, contractors, city officials, you name it…
This is the hardest work any of you will ever do, period. You better have a reason for doing this that’s more significant than money or fame.
Knowing this, I don’t think I want to work for less! I am going to get paid, and paid well, with anything and everything I do, or I don’t play.
And this is why I can only pay for assets what I can pay. When starting out, I had to kiss frogs. Now, I don’t have to.
Investors: Which metrics weigh most heavily in your decision to buy investment property? Do you agree with my assessment?
Leave your comments and opinions below!