Is there a better way to evaluate real estate?

Question

People are generally in one of two camps on real estate, it's all about CAP rates or it's all about cash flow and the cash-on-cash return. It seems that neither is exactly correct, and neither is exactly wrong. When interest rates are really low or you can buy with close to no money down, cash on cash return seems to be how people evaluate real estate and when interest rates are high, it is all about CAP rate. I always wondered why combining both isn't a better approach to use.

As an example, is a CAP rate of 8% or 12% or whatever number you use always a good investment? I’d argue that in 20% interest environments, buying a 12% CAP rate would cause you to go bankrupt if you are using debt service in any way. I’d also suggest buying a 12% CAP in cash is probably not appropriate as you would not be competing against anyone that has to use debt service. Based on all of this, is there a better way to evaluate real estate?

I would propose a better way of evaluating real estate and that is to take the difference between the CAP rate and prevailing interest rate and use that to evaluate whether something is a deal or not.

D = CAP - %APR

This would allow you to calculate the spread which is directly related to your debt assisted profitability (like a cash on cash return).

You can vary what “D” you will accept based on the normal factors you would consider when thinking of the CAP rate (location, building type, number of units, financing, deferred maintenance, etc).

You could also rearrange the equation to calculate the CAP to search for opportunities and how to offer for property:

CAP = D + %APR

In this case, you can actually figure out the CAP by knowing the “D” you want to get for a given location, building type, etc and understanding the financing available to you and other investors for the opportunity.

Any reason this is an inferior approach to CAP rate or cash on cash return?

David Song · Answer

@Samuel Eddinger you are a smart man. I picked up from one guy who mentioned the spread on BP a long time ago. This is the best method for evaluating rental properties, not the 1% rule. As long as we remain humble and are willing to learn from others, those little things will manifest their true power.

As interest rate move up, in general, the cap also shall move up. Then price will drop. However, in the same time, when interest rate goes up, there tends to be an inflation pressure building up, which may push the rents higher. Therefore, it is a very complicated mathematical model.

Samuel Eddinger · Answer

Thanks for the feedback.  I like that it is pretty simple but has flexibility because it has the affect of financing rates.  People should buy a higher CAP rate in a higher interest rate environment so it helps to normalize that (whereas CAP rate has no impact on debt service).

I tend to think of myself more as a CAP rate guy but I hate that people are buying for cash on cash with terrible CAP rates.  I figured this is an easy way to normalize it and make sure that you are not overleveraging.

Bruce Woodruff · Answer

IMHO, you're overthinking this. Are you looking for an immediate return on your investment? Good monthly income? Are you willing to have neither and wait for an area to gentrify?

Samuel Eddinger · Answer

@Alecia Loveless - That's the problem though.  If you are too leveraged, COC rate of return isn't meaningful and can get you into a lot of trouble.  Any downturn or tenant issue can make your COC rate go negative and then you can be in lots of trouble.  I think COC is very dangerous with high leverage ratios.

David Song · Answer

@Samuel Eddinger This is not new. A lot of people have used this exact evaluation method for many years. The spread between cap rate and interest rate. I use this method all the time. 3% spread is very good for my criteria. 2 % is marginal. 1%is bad.

Alecia Loveless · Answer

@Samuel Eddinger I look at CoC return on investment and cash flow as well as how I think the overall investment will hold up in the long term given it’s location. ie is the location going to improve, get worse, appreciate, depreciate.

I’m my market CAP rate isn’t even a thing.

Samuel Eddinger · Answer

Thanks for letting me know.  I have never seen it in the literature so I thought I was on to something.  I agree 3% is generally my spread target or possibly higher depending on the area.  This is also why I buy properties with 30 year notes as I can still get less than 4% mortgages.  I'm still trying to get 8% CAP rates where I can.

Jon Kelly · Answer

@Samuel Eddinger I actually think it's a rather simple approach and think it's something you can use going forward. I'm curious what others have to say. The reason CAP rates are popular is because it removes the financing variable and allows investors to analyze deals on an equal playing field. The assumption is that you are well aware of what your own financing % is, maybe 3-5% for example.

By using "D" you can quickly determine if it meets your "D" threshold or not.

Another way to do this (and I think a lot people do) is look at several metrics and determine if it meets their goals or not (e.g. CAP rate, COC, IRR, monthly cashflow per door, etc.).

Samuel Eddinger · Answer

I appreciate your feedback.  I own 20 properties but am an engineer by training and now own a property management company so I'm hyper analytical but definitely not an analysis paralysis guy.  I just think in areas that are not speculative plays like New York City, this may be a better approach.  I get it if their is some other intangible about an investment, all evalutation methods go out the door.

Is there a better way to evaluate real estate?

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