Jon, you raise a very valuable point. Everyone who gets involved in real estate should have it tatooed onto a visible body part, where they can refer to it easily:
"Speculating is not the same as investing."
Speculating involves definite high risk with possible high reward, usually over a short time frame. The speculator typically has little or no control over the outcome of his bet.
An investment is an attempt at long-term accumulation of wealth. The reward is likely to be smaller but so is the risk. And with a good income property, you don't have to rely entirely on forces that are out of your control to maximize your return.
This thread started on the subject of cap rates and meandered a bit into commentary on a number of other measures. Let me add my one cent (used to be two, but I had them in the stock market):
I think it's incorrect to label any of these measures or techniques -- cap rate, IRR, DCR, pro-forma analysis, etc. -- as useless or irrelevant. In my opinion, the informed investor understands all of these, and more, and recognizes that they have different purposes and can satisfy different objectives.
For example, on the original subject, cap rates. You may be looking to purchase a small office building, and find two or three candidates in a particular zip code. You also find that the last several properties like these, in this location, sold at cap rates between 8% and 9%. After you reconstruct the owners' representations about the properties for sale (i.e., after you verify the rents and the major operating expenses like taxes and insurance, and apply your own experience about the typical costs to maintain and the amount you need to allow for potential vacancy), you decided that these properties are being offered at something closer to a 5% cap rate.
Before you spend any more time or effort considering these properties, you know that, at their asking prices, they are not worthy competitors for your investment dollar. If comparable properties yielded 8% or more, you feel justified in settling for no less of a return. It is simple math to calculate the price at which each of the properties might begin to make sense. You may decide simply to move on to some other investment that will meet your objectives better.
At the same, you recognize that satisfactory cap rate is not sufficient to make a decision to invest, because cap rate is a measure at a single point in time. You decide that "long term" means at least seven years, so you develop pro forma projections going out seven years: income, expenses, cash flow, potential resale. Crystal ball a little cloudy? Of course, you don't know precisely how these variables will progress over time, but if you can probably make reasonable assumptions based best-case, worst-case and perhaps a few in between scenarios. Things seldom go as well as you hope or as bad as you fear, so the property will probably perform somewhere between the best and worst cases. You may look at a time-weighted measure like IRR. Can you live with performance like what you see between the extremes?
For your re-sale projections, if this is a real income property like an office building, forget the word "appreciation." Income properties don't rise in value because of the passage of time. They rise, if at all, because they produce a greater income stream. The person who buys from you in seven years will do the same kind of analysis you're doing now and will pay accordingly. At what price will the property offer a reasonable return down the road to a new owner?
And do you care about Debt Coverage Ratio? The banks want to know if your NOI is going to be sufficent to cover your debt service, with about a 20% cushion for error. You should be no less concerned. It may sound great that you're using no money of your own, leveraging the property to the limit, but that property's debt may then become a hungry demon.
Different measures, different techniques, different purposes. Don't discard them. I think each can tell you something you need to know to make an intelligent investment decision.
