Cap rate underwriting is an incomplete approach on assessing deals. The drawback of cap rate is that the metric only looks at EBITDA over All In at a point in time but not account for the whole investment horizon.
Cap rate could also be deceiving as rental income fluctuates due to several factors: market conditions, regulations, management/owner knowledge/experience, and others...
If you are looking for a healthy cash on cash return, you would need 200-250bps of spread between the bank financing and going in cap. For example, if you are getting 4% interest rate from financing, you should aim for 6%~6.5% going-in cap. The spread allows you to achieve healthy cash on cash return. Granted, there will be other financing terms that will juice up your return: interest only and longer amortization.
For Los Angeles, the play would be value add/opportunity driven. We often went in a deal with negative cashflow since the property is either distressed or required complete ground up construction. After we stabilized everything, we try to pull as much of our cost out and sit on the free cashflow. It will have to be a balance between appreciation, cash flow, and vesting term.
That being said, there's also an exception where you can buy in-place high cap in LA. I experienced that moment back in 2008-2011, where you can easily get a 7% cap on any of the condos in downtown los angeles. Property value has dipped around 35%~50% from 2007 peak.
