All Forum Posts by: Immanuel Sibero

@Blondell Chism

It's a marketing gimmick. Many investors wrongly look for "high" cap rates so saying high cap rate would attract attention. Cap rate is irrelevant in single family houses, duplexes, triplexes and fourplexes. Even in commercial multifamily properties (5 unit and more), cap rate is used as a valuation metric so investors in this space should not be chasing cap rate either. You should do your own underwriting using industry standard/best practice metrics such as COC, IRR, Equity Multiples, Payback in years, etc.

Cheers... Immanuel

I see IRR frequently used in real estate but not NPV. IRR is more of a performance metric and NPV is more of a valuation metric.

When it comes to real estate valuation, COMPS, PPU (price per unit), capitalization rate are some of the more common valuation metrics I see used in real estate as opposed to NPV.

When it comes to performance metrics in real estate (of which IRR is one), I agree there are numerous and it can be confusing as to when to use which. I'm a relative newbie and went through this and found it helpful to first understand what each metric is designed to measure in the first place before deciding which one is needed for my analysis. Below is a quick summary:
 

Generally, the four sources of return in rental real estate are:
1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings

Examples of performance metrics and what they are designed to measure:
- CoC (Cash on Cash) is a measure of net return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis.

- Equity Multiple (ROI) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. Equity Multiple does NOT take into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- IRR (Internal Rate of Return) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. IRR takes into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

Cheers... Immanuel

Your question is about valuation, and about analyzing a property for potential acquisition. From a valuation standpoint, the calculated cap rates in your original post and some of the other posts here (the 5.3 and the 6.6) are irrelevant and essentially useless.

In your initial post, you mentioned the average cap rate in the area the property is located is 6.4. I’m assuming you obtained this 6.4 cap rate from reliable sources such as local commercial brokers, bankers, other investors. If so then THIS is the cap rate that matters! This is the ‘market’ cap rate! It’s even better if this 6.4CAP was the average cap rate of recent sales involving a property similar to 15-unit apartment building you’re analyzing. These recent sales are the COMPS for the 15-unit apartment.

The 6.4CAP is what the market (i.e. potential investors) uses to value properties similar to the 15-unit apartment (NOT the 5.3 or 6.6, again they are irrelevant). Investors are looking to buy NOI (the building, parking lot, the yard, etc. simply come with the NOI). A 6.4 market CAP means a dollar of ACTUAL and VERIFIED NOI is worth $15.625 (or $1 / 6.4%). So the estimated fair value of the 15-unit apartment is 132,000 * 15.625 = $2,062,500. It’s important to understand that this 6.4 market cap rate is exactly that… market! Meaning it is determined by the market. You have no control over it.

The listing says the property has a 5.3CAP (again, you should ignore this), but as you have figured out, the asking price calculates to be 132,000 / 5.3% which is $2,490,566. So we can immediately see that the seller is asking for a PREMIUM of $428,066. The agent says that the building could have rent growth to a 6.6CAP (again, you should ignore this). A couple of problems with this:

•  The seller is asking for a price that includes what the property could potentially do, not based on actual. I don’t know how you feel about purchasing something potential instead of actual.
•  The agent tries to make a case that the property cap rate could increase from 5.3 to 6.6. An increase in cap rate is a good thing, right? Well it depends. In this case, I can easily make the argument that the potential increase in rent would increase the value of the property by approximately equal to the PREMIUM seller is asking (as stated above). So the agent is really suggesting that the seller should reap the benefits of potential rent increase, but the buyer should the work. I don’t know how you feel about someone else reaping the benefits of your hard work!

There is a lot of misconception about cap rate, it is often misused as a performance metric which leads to questions such as "what's a good cap rate?", "what's the minimum cap rate I should accept?". No such thing as a "good" cap rate or "minimum acceptable" cap rate. The claim that the agent makes is also a misconception/misuse of cap rate. You don't acquire a property, then increase the cap rate, then sell for a profit. Cap rate is market driven, you have no control over it, so you can't increase or decrease it. Instead, the correct process is you acquire a property, increase NOI, then hopefully sell for a profit (when you go to sell, you're still at the mercy of the prevailing market cap rate over which you have no control). So It's the NOI that needs to be increased or enhanced because NOI is what investors are out there to purchase. They're not looking to buy cap rate, they're buying NOI. This is also the reason why calculating the cap rate of the property by plugging in numbers into the formula (NOI/Purchase Price) is just useless. Worry about NOI not cap rate. Some poor investor out there might think this 15-unit is a good buy because, well… cap rate could increase from 5.3 to 6.6!! The higher the cap rate the better the deal, right??? Nope, that's a misconception!

Cheers… Immanuel

Our economy has been humming with close to zero interest rate for too long that many of us have forgotten how things work on the flip side. The idea that COC always gets better as you put down less on an investment (classic leverage) generally holds true in a low interest rate environment, especially in the "artificially" low interest rate environment created by the Fed. Well the Fed changed all that and they changed it in a hurry, catching a lot of us by surprise. Your project pays 6%, if you finance it with 8% int rate then the COC behavior that you observed is expected. Every dollar you put down replaces a dollar of mortgage costing 8% with 6% of profit. That's why your COC goes up as you put down more.

So the answer is we are operating in a flipped environment, profit is low interest costs are high. So it would make sense that COC behavior is flipped as well. Bottom line, your and your wife's spreadsheets are probably just fine :-)

Cheers... Immanuel

82% ROI seems too rich for me. Using the same facts, I would calculate as follows:

Proceeds (net of 6%): 340,000 - 20,400 = 319,600

Cost (all in): 260,000

Profit: 319,600 - 260,000 = 59,600

So ROI is: 59,600 / 260,000 = 22.92%

Note: 1. To me, "all in" means all cash PAID. Since I didn't really pay cash for the 6% sales cost, then it's really not part of "all in". I see it as part of sales proceeds. So the 20,400 is a reduction of proceeds NOT cash paid in. 2. My calculated ROI of 22.92% means for every dollar I put in the project I get my dollar back PLUS a return (profit) of 22.92 cents. So if I put in 260,000, I get back 260,000 PLUS a return of (260,000 * 22.92 cents = approx. 59,600). In total I get back 260,000 + 59,600 = 319,600 (which ties back to my sales proceeds - net of sales costs)

@Steve Haake

@Steve Haake

COC ROI is certainly a metric to look at when analyzing a deal but I would make sure I get a big picture of the deal because COC does not tell the whole story. Some ideas to consider below:

The four sources of return in rental real estate:
1- Cash flow
2- Loan paydown
3- Appreciation in value
4- Tax savings

Some examples of metrics used to measure the above sources of return:
- CoC (Cash on Cash) is a measure of net return generated by TWO sources (i.e. Cash flow and Loan paydown) on an annual basis.

- Equity Multiple can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. Equity Multiple does NOT take into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

- IRR (Internal Rate of Return) can be used to measure the net return generated by ALL FOUR sources (i.e. Cashflow, Loan paydown, Appreciation, and Tax savings) throughout the life of the investment. IRR takes into account the time value of money. In practice, the effect of tax savings is usually not included because it can be complicated to calculate.

So it's worth repeating that COC is a measure of only two sources of returns from ONE year (usually the most recent year). On its own, COC is hardly sufficient to make a purchase/no purchase decision...

Cheers... Immanuel

But nonetheless, the application is if the cap rate (NOI/PP) is equal to the mortgage constant (DS/LA), then the differences are equally proportional, and that's the cash on cash (NOI-DS)/(PP-LA) by definition.

I was not a math major, maybe that's why I'm having trouble answering your question. But I feel like I'm going in circle. As normally defined, COC = CF/DP where CF is Cashflow and DP is down payment. I can restate your statement above with substitutions in bold font... and it would also be true:

But nonetheless, the application is if the cap rate (NOI/PP) is equal to the COC (CF/DP), then the differences are equally proportional, and that's the Interest (NOI-CF)/(PP-DP) by definition.

Are you NOT interested in the “why” for this proportional equality?


By the way, the same is true for a regular loan, not just interest only!

Interest Only has been a necessary assumption in all my responses, so I don't agree with this statement. If you were to amortize the loan by 1 dollar, COC would go out of synch (i.e. no longer equal to interest rate or cap rate). But since you made the claim, you have the burden of proof... lol. So how would you show that with an amortizing loan, when i = C, then COC also = C?? I just don't see it possible.


Last comment for today... here's another quote from your earlier post:
I've written it all out with actual math proofs for myself. I can't believe this doesn't exist anywhere. Can't find it anywhere online. It's incredibly helpful for analyzing an existing portfolio or a new acquisition since you can very quickly understand what adding debt to a property will or will not do to it's COC.

So, property analysis seems to be your bottom line (i.e. not necessarily the math connections between debt and COC). Well I made a post quite sometime ago that covers exactly this, that is, the impact of debt terms on COC... So YES, it does exist and it's been written before :-) Here is the excerpt:

I was evaluating a property with the following metrics:
Cap Rate: 6%
Interest Rate: 4%
LTV: 75%
Since the spread between cap rate and interest rate was slim (2%), I knew COC would be low. Since low COC means running the risk of negative cash flow which means risk of not paying the loan, I wanted to know how the various loan terms affect COC. For example, how sensitive was COC to the Cap and Int spread. This can easily be done using sensitivity tables in Excel. Based on the financial data of the property, following are two sensitivity tables:

As you can see, my Cap rate - Int rate spread is 2% and from the first table it puts my COC at 2.39% which is concerning. Note that this table shows how sensitive COC is against the spread.

Second table shows how sensitive COC is against LTV. It shows that 75% debt is about the most I should borrow. Anything higher can put me in negative cashflow. HTH

Cheers... Immanuel

@Kim Hopkins

I'm having trouble answering... lol, how about alternative answers below:

- Based on the formula I laid out, when cap rate is 10% and interest rate is 10% then by definition COC is 10%.

- As owner, your portion of the property's rate of return is residual (whatever is left). Lender's portion of the property's rate of return is contractual (first dib). If the lender's contractual rate of return is higher than the property's rate of return, then the owner's rate of return would be lower than the property's rate of return... and vice versa. By the same logic, if the lender's contractual rate of return is the same as the the property's rate of return, then the owner's rate of return would necessarily have to be the same as the property's rate of return.

- If cap rate is 10% and debt holder demands 10% then COC can NOT be higher than 10% because this would require cap rate to be higher than 10%. In the same way, COC can NOT be lower than 10% because this would require cap rate to be lower than 10%. So COC has no choice but be 10%!

Which of the above do you like? :-)

Cheers... Immanuel

@Kim Hopkins

After reading through the formulas you had, below shows a shorter way to get there. Please review and comment (I'm using the same variable names):

NOI = C * PP
DS = i * LA
DS = C * LA ---> because i = C

COC = (NOI - DS) / (PP - LA) ---> by definition as you pointed out.

Substituting NOI and DS, then:
COC = ((C * PP) - (C * LA)) / (PP - LA)
COC = (C * (PP - LA)) / (PP - LA)
COC = C ---> so COC = C = i

 Cheers... Immanuel

Okay. I took a quick read at your post and saw the formulas so initially I was going to wait till this afternoon to respond. But then I read your last paragraph with the burning question: Why is the COC also equal these rates? Well I'm going to try to answer without going through the above formulas since I think there may be a quick and simple answer. Hopefully this works:

Say you acquire a property with 10% CAP Rate. If you pay all cash then you get all the 10% CAP Rate (i.e you call this 10% COC). If you use Interest Only debt, it simply means you're sharing the 10% CAP rate with someone else (i.e. a debt holder) in such a way that part of the 10% CAP rate becomes COC (i.e. paid to you) and the other part becomes INTEREST (i.e. paid to the debt holder).

In this scenario, IF the debt holder demands 10% INTEREST can you see that you, as the owner, would also get 10% COC? The reason for this is because the property happens to be paying 10% CAP Rate, so everybody gets 10%!

IF the debt holder only demands 8% INTEREST then you as the owner would get more than 10% COC... this is because the property spits out 10% CAP Rate but the debt holder is happy with 8% INTEREST, so the residual (which would be higher than 10% COC) will go to you, the owner.

I will reread your post in its entirety later and comment further.

Cheers... Immanuel

“If you buy Property A WITHOUT debt, then CAP Rate = COC because Debt Service = $0 so Cash Flow = NOI and Purchase Price = Total Cash Invested.”

I agree with your statement above.

But, in theory you could buy a property WITH debt where CAP Rate would still = COC. When you finance a property with loan where 1. Interest Rate is equal to CAP Rate and 2. the loan is interest only loan.

The impact of debt on COC is the net impact of each of the debt terms. It therefore helps to examine each term of the debt and how the terms individually affect a property's Cash Flow (or any business for that matter). Three factors to consider are – Interest Rate, Amortization, and Loan to Cost/Value. Following are several scenarios to help understand the relationship between CAP Rate and COC:

• - When debt is used where Interest Rate is equal to CAP Rate, and no amortization (as mentioned above). CAP Rate generally = COC. NOTE: This is true whether LTV is 75% or 25% (i.e. LTV does not matter).
• - When debt is used where Interest Rate is less than CAP Rate, and still no amortization. In this case COC will increase and exceed CAP Rate (i.e. this is classic leverage strategy, it's why corporations issue corporate bonds). ALSO NOTE: LTV still does not matter here.
• - When debt is used with amortization, then obviously this will reduce COC as you're using Cash to repay the loan. This is also the scenario where LTV finally comes into play – the higher the LTV, the higher the amortization, the lower the COC.

Cheers... Immanuel