Shed some light on this discussion.
In this case, we’re talking about a 10 unit apartment building. Here are the facts as we know them:
Asking Price: $575,000 (irrelevant)
Gross Monthly Rents: $5,450
Stated Expenses: $1,350 (bogus)
Here is how I would analyze this deal if I were buying it. To be conservative, I would assume operating expenses to be 50% of gross rents. That means NOI = $2,725. The only real variable left is the mortgage payment. I could get money from my small local bank at 8.25%. I know CHiBroker claims to be able to do better - good for him. The money will cost me 8.25%. I do not put money down, although I don’t have a problem with people that do.
As a general screening tool, I must have monthly gross rents that are 2% of the purchase price. By this swag, the maximum purchase price would be $272,500.
I need positive cash flow from my properties each month, because I like to eat and ski. My minimum is $100 per unit per month.
Therefore, the maximum mortgage I can pay is $1,725 if I want to make $100 per unit per month. Plugging this into a mortgage calculator, the max I could pay for this property with a 20 year loan is $202, 449. With a 30 year loan, the max would be $229, 612. Obviously, if I put money down or got a better interest rate, I could pay more.
In addition, I never pay more than 70% of the market value for a property. I have looked at hundreds of properties in my local area and know the market values. As personal confirmation, the bank’s appraisal always comes out close to what I had estimated. Of course, this situation is not in my market, so I am not personally familiar with their market values. However, based on experience, I would be willing to bet that a purchase price of $202,449 is at least 30% below market value.
So, what value does cap rate add to this equation? In reality, haven’t I really already considered cap rate since we are using market value and NOI in the evaluation? After all, cap rate is NOI/value. You’ve got to know 2 of the 3 variables to solve for the 3rd.
Also, we know that for small residential properties, the vast majority of new investors fail. Therefore, if we determine a market cap rate for these properties, aren’t we actually determining the market price that the average failure paid? I realize that as we move up the food chain with larger and more expensive properties, the failure rate goes down and the market value MAY be a little more relevant.
I’d like to get your take on this.