To Cap Rate or Not to Cap Rate?

Question

Hello to all. Please provide feedback on prioritizing the numbers in the calculators.

- Is there a website or tool to help real estate investors find the average cap rate in a neighborhood or City?

- Should I concentrate on ROI? (Which I think is more important)

- I would assume the Cap expenditure is greater in C and D areas. How much extra conservative should it be? Is there a website or tool for that?

My understanding is that it all depends on the class of neighborhood. I am trying to stay in the D+ transitioning to C, all opportunity zones in New Jersey. My focus is to purchase M/F apartments in Paterson, Passaic, and selective parts of Newark. Possibly look into the C+ areas are Clifton, Garfield, Plainfield, Fairview, Lodi, Hackensack.

I am currently working on a list for wholesalers in the area to send me properties. The goal is to be on the top of each wholesalers list.

- Can a wholesaler please provide an example of what a buyer usually asks?

I look forward to hearing what you all have to say.

All the best.

Corby Goade · Answer

This is one of my BP pet peeves that is rarely addressed. Cap rates are not designed for residential investments and don't give an investor a true picture of the return they can or should expect. The value of residential properties is based on sales comps- people pay market rate for residential properties based on what other properties in the area have sold for. Depending on your exit strategy, your ability to profit from a sale or leverage your investment is solely based on sales comps.

Cap rates value commercial properties based on the NOI. You could have two identical commercial properties next door to each other with totally different caps solely based on the quality of the management- this would not happen with residential investments. Of course, when real estate is doing well, as it is now, investors will buy commercial buildings based on speculative caps if they can force equity through more professional management.

I'd focus on a metric that is better suited to residential investing- cash flow, ARV, CoC, whatever aligns with your investment goals, but using a cap on a residential investment won't give you appropriate valuation on your return.

Good luck!

Corby Goade · Answer

@Guido Sanchez, you bet, happy to help. I hesitate to give other investors advice on how to evaluate a deal because every market and neighborhood is different and every investor has a different financial situation and threshold for risk. Personally, the metric I am using for the last few years has been my ability to force at least 25% equity in six months or less. If I can do that, I should have several exit options available to me.

Dave Foster · Answer

@Guido Sanchez,  Cap rate in its purest form is simply a measure of the net income (before debt service) as a ratio to purchase price.  It takes debt and appreciation out of the equation.  Which is why it's a great comparative metric for commercial.

It took me a while to come around to this thinking as well but for an investor who is not focused on appreciation and is truly looking at net revenue performance cap rate can be used successfully to evaluate performance.  The problem you have to watch out for is looking at the debt portion separately but carefully.  Because debt both impacts NOI and net equity which is something you want to have an eagle eye to when using a Brrr strategy.  And of course for a cash flow investor appreciation is just a happy accident!

Guido Sanchez · Answer

@Corby Goade

That was the hunch I had, I just couldn't put it into words. My strategy is to use the BRRR method to buy and hold. If I need to sell anything I intend to 1031 exchange them to another market. Get a snow ball going.

Which metrics should investors focus on when applying the BRRR method on 2-4 residential properties?

Any books or websites would be greatly appreciated.

Thanks for the clarification, it means a lot.

James Mc Ree · Answer

@Guido Sanchez Just to set proper expectations, due diligence and learning is much more than a 1 week activity.  You can easily spend several months looking for a good deal.  Don't settle for the best deal you can find the 2nd week of February.

Get to know the areas you are shopping in detail.  That alone usually takes more than a week.  Go through listed properties to get eyes on what they are really offering.  Look at sold prices for properties as those are your comps.  Look at rental offerings too if you are shopping for a buy & hold.  Model potential purchases so you can see how your numbers work out.  (BP has a calculator for this!)  Read and learn all you can while doing this and talk with lenders about what you qualify for.  Get to know contractors if you expect to need them.

Jaysen Medhurst · Answer

@Guido Sanchez, cap rates are super local and can vary by neighborhood and asset class. You really need to talk to brokers or other investors in the area to understand where cap rates stand.

• ROI is important, of course, but it isn't the only thing to think about. I recommend looking at Internal Rate of Return (IRR), which looks at the profitability of a property (cash flow, appreciation, depreciation, mortgage pay down) against other investments, e.g. the stock market. For a deep dive, I highly recommend What Every Investor Needs to Know about Cash Flow by Frank Gallinelli.
• Cap Ex won't necessarily be higher in C-D neighborhoods (roofs wear out at the same rate), but repairs and turnover costs will. As a general rule, 7.5% of Gross Scheduled Rent (GSR) each for repairs and CapEx.
• If you want to get to the top of wholesaler's lists, close. It's as simple as that.

Guido Sanchez · Answer

@Corby Goade,  thanks again for sharing what has worked for you in the past. Having multiple exit options is one of the reason I prefer to go slow and do the BRRR

Guido Sanchez · Answer

Thank you @Dave Foster for that information. When the time comes I look forward to using your services.

Guido Sanchez · Answer

@James Mc Ree

I appreciate the guidance. Definitely not going to rush into anything. I've been looking around at too many places and getting distracted by what seems to be a "deal" in too many areas.

Some background... I already owned a 3 unit multi-family back in 2005 for 5 years. Unfortunately, I was conned by a contractor and ended up taking an interest-only loan to finish the job. Needless to say, I had to get rid of that house and regroup. I've passively invested in a Mortgage Note fund. Love the passive income but ready to get more skin in the game after marriage, kids, life and 9 years "waiting" for a downturn in the market.

I was afraid to get on BiggerPockets before because I am not a fan of Social Media. BP is a great community, not just a website, I had no idea what I was missing.

I will keep you posted on my progress.

Thanks again for your help.

Guido Sanchez · Answer

@Jaysen Medhurst

Thank you so much for the feedback. Because of your insight, I will focus on 1 area, write down and learn all I can for about a week. I've been a bit scattered and overwhelmed with information. So I don't want to take a shortcut and make a costly mistake. (Again)

I have the desire, the cash, and working on a team to do the BRRR method at least once this year. Then I'll ramp it up slowly from there. Ordered the book from Amazon and I look for to deep dive on the numbers.

Very much appreciate the time and the information you provided.

All the best to you and the family.

To Cap Rate or Not to Cap Rate?

Most Popular Reply