Property Management Blog

Is there a better way to evaluate real estate?

Ironclad Property Management - Monday, March 7, 2022
Property Management Blog

People are generally in one of two camps on real estate, it's all about CAP rates or it's all about cash flow and the cash-on-cash return. It seems that neither is exactly correct, and neither is exactly wrong. When interest rates are really low or you can buy with close to no money down, cash on cash return seems to be how people evaluate real estate and when interest rates are high, it is all about CAP rate. I always wondered why combining both isn't a better approach to use.

As an example, is a CAP rate of 8% or 12% or whatever number you use always a good investment? I’d argue that in 20% interest environments, buying a 12% CAP rate would cause you to go bankrupt if you are using debt service in any way. I’d also suggest buying a 12% CAP in cash is probably not appropriate as you would not be competing against anyone that has to use debt service. Based on all of this, is there a better way to evaluate real estate?

I would propose a better way of evaluating real estate and that is to take the difference between the CAP rate and prevailing interest rate and use that to evaluate whether something is a deal or not.

D = CAP - %APR

This would allow you to calculate the spread which is directly related to your debt assisted profitability (like a cash on cash return).

You can vary what “D” you will accept based on the normal factors you would consider when thinking of the CAP rate (location, building type, number of units, financing, deferred maintenance, etc).

You could also rearrange the equation to calculate the CAP to search for opportunities and how to offer for property:

CAP = D + %APR

In this case, you can actually figure out the CAP by knowing the “D” you want to get for a given location, building type, etc and understanding the financing available to you and other investors for the opportunity.

Using this will allow you to standardize how you evaluate real estate in different financing environments!