Rental Property Metrics Paralysis

Don’t Analyze Yourself Out of a Good Investment!

Purpose

• As an investor, it is important to have guidelines and parameters to base your investment decisions on. We often see investors focus on Cap Rate and Purchase Price.
• However, which guidelines and/or metrics you choose to focus on could cause you to lose out on good deals if you don’t look at the deal from a multitude of different angles.
• This episode will show a few hang-ups investors face, and why narrowly focusing on a single metric could end up causing thousands of dollars in opportunity costs.

Cap Rate

“I don’t want the property if it’s not at least a 6 cap.”

• Assuming we are using debt, let’s consider, how do you calculate Cap Rate?
  • Cap Rate = Net Operating Income (NOI) / Purchase Price
• NOI (and therefore Cap Rate) does NOT account for mortgage interest costs
  • i.e. if 2 identical assets have the same purchase price and NOI, then asset #1 with a mortgage interest rate of 3% and asset #2 with a mortgage interest rate of 5% have the same cap rate.
• Something to consider, is that Interest rates have been steadily decreasing over the past year; as prices of assets have been steadily increasing over the past year.
• When prices increase and NOI does not increase at the same rate, cap rates decrease (or compresses), which at its surface looks like a bad deal.
• Cap Rate is only capturing one part of that change, the increased price of assets.  It is NOT considering the decreased interest rate’s impact.

• Case Study:
• I own two identical properties across the street from each other.  I also refinanced them both almost exactly one year apart from each other. I refinanced Property #1 in late September, 2019 and refinanced Property #2 on October 1, 2020.
• For this analysis, let’s pretend we bought each property at their respective stated dates for the price listed.
• All other NOI factors remain constant except for purchase price and rent price, with the purchase price (25%) increasing at a higher rate than rent price (8%).
• This is a good comparison with both real interest rates and real appraised values to compare cap rate and interest rate effects.

Property #1

Property #2

Let’s Compare

Only looking at Cap Rate, this is what you probably are thinking…

Now, let’s look at the whole picture:

Even if we took out appreciation and looked just at certain or “more-certain” returns (cash flow, debt paydown, depreciation), it is a difference in ~$1,000 favoring Property #2’s numbers.  The only decreased ROI factor is cash flow, but a very marginal amount.  The debt paydown is higher, because the interest rate is lower (more going to principal each month), and the depreciation is higher due to the asset purchase price being higher.

Purchase Price

“I don’t want to pay anything above list price.”

• List price is a suggested price at the direction of a seller, usually supported by comparative sales that a real estate agent will present to the seller.
• There is a fine line between paying too much for a home and having a case of FOBO.
• FOBO: a term Patrick McGinniss coined which stands for Fear of Better Options in which people are paralyzed to commit to something out of the fear that it isn’t going to be the absolutely perfect option.

Example Property

• Offered $319,000 on an off-market duplex.  Seller countered at $329,000 which I immediately accepted
  • Only two other duplexes in the region available on MLS at the time of offer, one of which was listed at $900,000
• At its surface, $10,000 seems like a lot of money.  However, for a long-term investment, the constant cash flow debt paydown and appreciation will outweigh the additional upfront costs which in the future will go unnoticed.
• I could have succumbed to FOBO by turning down the deal or losing the deal by trying to negotiate.  However, by waiting around for a better deal I would have missed an opportunity to buy a cash flowing asset by not accepting the guaranteed offer in hand.

Original Offer Price

Countered $10,000 more in price

• Let’s break down the difference between the original price and the countered price:
  • $404 difference in yearly cash flow ($33.67/mo)
    • Original offer $5,664/yr and Countered offer $5260/yr
  • $318 more in 1^st year ROIQ with the countered price
    • Original offer $28,670 1^st yr and Countered offer $28,988 1^st yr
  • $2,500 more in initial cash down
    • Original offer $79,750 and Countered offer $82,250
• The only substantial difference I can see is the extra $2,500 down, but that will be replenished after about 6 months of cash flow.
  • Common FOBO Questions:
    • Will I find a better deal in 6 months?
    • How much will prices increase in the next 6 months?
      • At an assumed 5% yearly appreciation rate (lower than actuals), prices should appreciate on this asset over $8,000 in the next 6 months anyway.
• Key Observations:
  • Would you turn down $438/mo in cash flow if you were hoping for $472/mo in exchange for $2,500?
  • Are you willing to miss out on 5% appreciation while you wait to find a better deal?

Summary

• Avoid having a singular-analysis approach.
  • Focus on the whole picture and numerous metrics to analyze a property.
• Don’t miss out on a good deal today to hope for a better deal tomorrow.
  • Remember, you will make $0 a month waiting for the perfect deal that makes $350/mo instead of making $300/mo on a good deal now.

YouTube Video: Real Estate Metrics Paralysis