Understanding the dichotomy between Cap Rates and IRR in MF

[Matthew Metros]

To preface this email - I found a deal that resulted in a return of 8% over 5 years with a 2% rent increases YOY. 

My partner responded - 

"Might as well invest your money in the stock market and make 8% in a few days…Or go buy in Ohio, where the return is much higher.

Doesn’t make sense to invest at 8%, for me at least."

Overall the theme is that during the quick analysis, we found that rents are already at the market. If there’s no room for rental growth, then returns are not high enough for the deal to make sense.

So my follow up question is how do multifamily investors include asset appreciation in their returns.

If my thesis is that overall the San Antonio market is going to receive asset appreciation greater than the rents over x amount of years, how does my underwriting process change?

I ask because the cap rate is based on cash flow, while other investors seek ROI Based on the appreciation.

I understand that multi-family valuations are derived from cash flow. But what I want to understand is the dichotomy between the cap rate and IRR. IRR will include the cap rate PLUS the asset appreciation PLUS the leverage going into the deal.

So why do multifamily investors just focus on cap rate when IRR is clearly a more confident figure for your return?

I will admit that my question is largely due to my inexperience in the field. I am really trying to understand this.

[Taylor L.]

Contrary to popular belief, Cap rate is not a direct indicator of your return and it is not, on its own, an indicator of a good or bad deal.

It is much more accurate to compare cash on cash return and IRR. Cap rate does not include one of your biggest costs - the cost of debt. It also does not factor in your business plan. As @Peter Tverdov said, cap rate just indicates what the price is right now, with the current income and expense figures. 

Most of us are not all that focused on cap rate. It is one figure of many that influences the potential returns on a property. Also understand and calculate Gross Rent Multiplier, Price per door, debt service coverage ratio, breakeven occupancy, to name a few.

Also if your partner knows a reliable, repeatable way to make 8% in 2 days in the market, then yeah, why would you not just do that? You'll be ultrawealthy in no time at that rate. (My bet is they actually don't have such a strategy)

All that said, the strategy of banking on market appreciation in a particular area isn't one I'd recommend. Focus on finding assets that are currently under their potential market value today. Right now. Then bring those assets up in market value through value add. You have control over that business plan, you do not have control over market appreciation in San Antonio. That market appreciation should just be icing on the cake. 

Check out What Every Real Estate Investor Needs to Know About Cash Flow... And 36 Other Key Financial Measures by Frank Gallinelli. It'll teach you keys to the underwriting process. It is a little dated, but the math still all works the same.