How to determine a current market average rate of return...

Question

In a book I'm reading, and example was given thus...

"If the current market for a type or property required a 9% return on the capital invested..."

My question is how does one determine the current market "required" or expected, or average or fair cash on cash rate of return on a particular type of property in a specific area?

I can't seem to find this information anywhere.

Is there available data on this? Or is this an educated guestimate made by brokers? I think it would be great information to have in order to set a fair market baseline when looking for income properties.

Thanks.

Jon Holdman · Answer

Here's a dead simple way to compute the max price for a pure income property.  This doesn't account for appreciation, "tax breaks", or any of the other monkey business that can be used to make a deal look good.

Start with the rent

Estimate the expenses, 50% for a conservative assumption, maybe a little less if you're more optimistic

Subtract expenses from rent to get NOI

Subtract off your desired cash flow.  For example, $100 per unit per month

That gives you the amount you can afford for a P&I payment.  Assume 100% financing, which is just giving yourself the same return on any invested cash as the loan rate.  This is just the P&I payment, taxes and insurance are in expenses above.

Compute the loan value for that payment.  In Excel, use the "PV" function.  Use whatever loan terms you can get.

Viola there's you're price.

Now, do your due diligence and verify there's nothing going on that will make expenses higher than your assumption.  If you want to survive in the business, don't just start lowering your expenses to make it work. For sure, don't fall for the line that the only expense are taxes and insurance and the property will always be filled (i.e., cash flow = rent - PITI payment).

Michael Rossi · Answer

Scott,

Assuming that you are not talking about large commercial buildings, then this is just nonsensical gibberish.  There is no "market required" return on a particular type of property.  In fact, for any type of property, there is a wide range of returns being made - from people taking a large loss to people making a significant profit.

For example, in the residential rental business, the vast majority of newbies fail in a relatively short period of time.  If you looked at the Market Cap Rate for the area (which is a big joke itself, but that's another story), that would theoretically give you the NOI for a given price.  However, since we know that the vast majority of newbies fail in the rental property business, what that number really tells you is what the FAILURES were paying for their property.

The bottom line is that accurate numbers do not exist for relatively small properties for "market required" return or "fair cash on cash return", etc.  It's up to you to decide what rate of return is acceptable for you.

There are some very good discussions on this topic under the heading of "Cap Rate."  You could use the search function at the top of the site to find those previous discussions.

Good Luck,

Mike

Scott Kelly · Answer

Mike,

Thanks for the reply.  That's pretty much what I figured. I will start digging through the Cap Rate topic for more info.

Regards,
Scott