Inexperienced investors often make judgments solely on Cap Rate. In this article, I’ll explain why Cap Rate alone doesn’t give you a complete picture of an investment’s potential and how you can virtually guarantee a profit by using the more complete picture painted by the Holy Trinity Of Investing.
What Is Cap Rate?
First off, Cap Rate is a ratio of two numbers; Net Operating Income (NOI) / Price. What that means is that Cap Rate is a relative comparison. True, it’s a preliminary indicator of property value, but it’s real value depends on your perspective (whether you’re a buyer or seller).
Cap Rate by itself it doesn’t give you any indication of Cash Flow, which is extremely important if you want to keep your project from stalling and keep your investors happy throughout the project.
Cap Rate is also a measure of risk (which is why many investors search for properties based SOLELY on Cap Rate). Lower Cap Rates (6/7%) will have great tenants, high rental prices and low vacancies. They offer long-term stability.
Higher Cap Rates (10-14%) will usually accompany distressed or run-down properties. Keep in mind though, higher risk brings with it an opportunity for higher ROI.
The problem is, Cap Rate (NOI/Price) is calculated BEFORE debt service. So it tells you if you’re getting a good price (effectively determining your purchase price), but doesn’t tell you what will be left over after making that mortgage payment!
What’s The Cash Flow?
The other side of that coin is Cash Flow. Cash Flow adds Debt Service into the equation.
Banks use Debt Coverage Ratio (DCR) which is NOI/Debt Service or NOI/P&I.
That means a DCR of 1.0 will allow you to pay the mortgage — but that’s it!
For a multi-million dollar project, banks will require a DCR of 1.20-1.25 to insure that the property is rented enough for stable income. That way, you have enough of a cushion to cover the loan even if you unexpectedly lose some tenants.
While banks are ok with a DCR of 1.20-1.25, in practice you’ll want something more like 1.6 (you want a LOT of cushion) so that you can pay yourself and your investors.
To figure out if the DCR is enough, we need to calculate the Return On Investment.
Depending on the length of time to complete your project, calculate either standard ROI or IRR (internal or multi-year ROI).
ROI is pretty straight forward when it comes to a quick flip. Take all your expenses and subtract them from the selling price. What you have left over is your ROI (Cash Flow / (Purchase Price + Renovations)).
IRR is for projects you’ll hold onto for a year or more. This would be for larger projects that will take more time to renovate and flip (multi-unit apartments for example) but may be collecting rent until the project is completed and sold.
IRR is basically a multi-year ROI because it factors in rents collected to give you a true cash flow. For more information on calculating IRR, here’s a post.
The Holy Trinity Of Investing
So we’ve got Cap Rate which gives us the target purchase price. 8% is your MINIMUM.
Then there’s DCR which is true cash flow after debt has been paid. The minimum DCR you’re looking for is 1.6.
And lastely, ROI (or IRR) which tells you how happy your investors are likely to be. You’re looking for a minimum of 12%.
To get a true picture of an investment’s potential, all three of these indicators have to be considered.
What’s more, if you know what ROI you and your investors are looking for, you can manipulate the other two indicators — effectively setting your Cap Rate and making it a little easier to find the right investment opportunity.
We call these three numbers the Holy Trinity of Investing because if you have all three numbers, you know everything you need to know about that investment, at a glance. Having the right values (Cap Rate, DCR & ROI) is as close as you can get to having a guaranteed money maker!