just couldn’t stand it could you! - Posted by ray@lcorn
Posted by ray@lcorn on March 06, 2001 at 20:20:49:
My how time softens memories. As Mr. Piper, Mr. Vaughan, Mr. Roach, Mr. Alexander, and numerous others will attest, the final result of that 2:00 am discussion in Atlanta last year was the esteemed Mr. Garcia saying, “Ray, you are right!” Remember? Terry even put a post on the board because it was such a surprise that you finally agreed with me.
I never said cap rates were not important. As a rule-of thumb type of quick measurement they are invaluable in culling deals. The question was how you determine the RIGHT cap rate to apply to a deal. Your position was that the market sets the cap rate, and the investor must pay whatever the market rate happens to be. My position was, and still is, that the savvy investor will derive the cap rate s/he must have for the deal based on 1)capital available and the required return on that capital; 2) his/her borrowing power as it relates to terms, rate, credit, etc.; 3) the amount of risk and effort required and the value the investor places on that, and; 4) the general conditions in the market.
When those factors are properly quantified, an investor knows before starting into a deal where the cap needs to be for him/her as an individual in order to achieve the predetermined investment goals. In this way, the price becomes a function of the investor’s criteria, rather than the product of an arbitrarily selected rate. If the market is soft, and the deal is priced at a higher cap, then so be it… the criteria is met and the investor can move forward with further due diligence. If not, s/he passes and looks for another deal, regardless of what the market says. I always have the option to not play if I can’t make what I consider to be a sufficient return on my money, time and effort.
Remember also that the only way to acquire an accurate cap rate for competitive properties (i.e. the market cap rate) is to know both the income and expenses. In my experience, no amount of research can ascertain true operating numbers from competitive set properties, unless you happen to own one of them. Brokers and appraisers can give you estimates, but unless they did the deal on the competitive property, and will tell you, then they don’t really know. And don’t forget that the broker has a vested interest in keeping the price high. That puts the number in the realm of a GRM, another rough guide to value. All of those rough rules of thumb have worth, I just won’t make a final decision on that information alone.
Cash on cash return is also only part of the picture. I do put more weight on it than a cap rate, because it accounts for deal structure and debt service. But again, I will not make a decision based soley on that number. It takes all the above and more for a deal to be a deal. There is no one acid test that says yes or no to a deal until you have evaluated all of the numbers.
Is cap rate useful? Absolutely. I just answered a post over on the mobile home board in which the asking price cap rate was 6%, on projected numbers no less. Any need to go further on that deal? None at all. I can make more on bonds and manage the investment from the golf course.
Look forward to continuing our discussion in Atlanta!