ARV or Cap Rate

I’ve seen a property that meets all my criteria and I want to buy and hold not flip. Property is on the market for $99,000. I want to offer 60,000 (which is minus 30 percent discount and repairs) Should I be using the ARV or the Cap Rate formula for buy an hold? Formula and example of both are below for all the newbies like myself. I got these calculations off the internet so if they are not right please let me know.

Capitalization Rate Formula

Formula: Annual rental income (income - expenses, not including mortgage)/ the purchase price = capitalization rate.

Example: If you purchase an investment property for $120,000 and it can generate $1,000 per month after operating expenses (not including the mortgage), then the cap rate would be $12,000 divided by $120,000, or 10 percent. This means it will take approximately 10 years to recoup the property value in net rental income if the rent stays the same (10 years at 10 percent = 100 percent). If the cap rate were 5 percent, it would take 20 years (20 years at 5 percent = 100 percent) to recoup the value.

After Repair Value Formula

Formula: The purchase price should be no more than 65 percent of the after-repair value of the property.

Alternate calculation method: 75 percent of your after-repair value - repair expenses = purchase price.

Example: You see an older home on the market that is visibly rundown and in a state of disrepair. Asking price is $160,000 “as is.” After you assess the damage, you estimate it will require $25,000 in new materials to get it in good shape. Homes of the same size in the neighborhood have been selling for $220,000 in “move-in, condition.” You would need to buy the home for $140,000 to make it a worthwhile investment. (75 percent of $220,000 = $165,000. $165,000 minus $25,000 = $140,000.)

I don’t find either formula that meaningful for a buy and hold property. If the property is a single family, then cap rate is meaningless as comparable sales determine the market value. ARV is only useful if you are flipping or doing a rehab-flip.

Buy and hold investors are not buying the property, they are buying the cash flow the property generates. You need to do a cash flow analysis then determine if the cash flow is sufficient to support the property, AND, if the ROI (cash flow divided by invested capital) is better than some other investment vehicle. If the answer to either question is NO, then you can figure out what your MAO needs to be to meet your purchase criteria.

That’s good advice from Dave.

Your goal, and only goal, is to make a PROFIT.

Buy and hold investors make a profit monthly with cashflow, or by getting rent checks. That’s passive income in which the CAP RATE formula would work best.

Flippers or rehabbers make a profit one time, with one big transaction. That is earned income in which the ARV formula would work best, but to be clear it is NOT the only formula that you’d use in a rehab.

I am a buy and hold investor at this point in the real estate game, and I use the APY formula to calculate my ROI (in lieu of a CAP rate calculation, though sometimes I use that method).

Additionally - a more intellectual, and sometimes vastly more profitable way to invest, is to combine the above methods and formulas. Say you buy a house at bargain price with lots of equity, which in turn you can rent for a few years or for ten or twenty years if you like, and then later sell it for a superb profit not only because of inflation…but because you got it so cheap in the first place. In that case you could use the CAP rate formula and ARV formula when calculating your return, but ultimately you’d want to focus on the ARV formula more than the other as since you’d focus on your RENTAL income for several years…and later on focus on getting even more money when you sell the place. Make sense?

I for one plan on switching to real estate full-time in a few years, but I want to generate money from not only renting (lower & middle income residential + commercial) properties - but also rehabbing (middle and upper middle income) properties to earn money both ways.

Good luck with your investing

Thanks dave and motivatedceo for the great information.

Good advice all the way around there.

Just make sure that when you buy you do so at a price that would permit you to exit the property without a loss, and preferably at a profit, as you just never know when you might need to sell. In other words, it’s not just about cash flow. So pull good comps, for both retail selling activity, as well as investor and REO selling activity in the area of your subject property. Probably good to focus on 2 or 3 zip codes initially and become an expert on these areas. Take a map of the area and highlight those blocks/pockets you’ll consider investing in (yes, drive it and rank average condition of properties on a block by block basis.) You need to be driving your area anyway, to identify vacant or neglected properties, which can become leads.

And when you estimate operating expenses, be conservative! Make sure that you factor in prop mgmt (includes ongoing fee and average lease-up charges, even if self managing, you never know when you might have to start using a PM), and make sure that you use at least 20% (of gross potential rent) for maintenance, turnover/make-ready, and replacement reserves. When you add all this up, expenses+vacancy+replacement reserves, it’s normally 45-50% of gross potential rent.

So when you calculate the cap rate, be conservative. Same with determining the market rent.

Let me say again, cap rate for a single family rental is useless especially if you are using financing.

Cap rate assumes that you own the property free and clear. Your Net Operating Income divided by your purchase price is the Cap Rate. In this one instance, it is also your return on investment.

However, you can have a property with a great cap rate, but have nearly all your operatiing income consumed by the debt service on the property. In this case, you have a great cap rate, but no cash flow.

This is why I said to do a cash flow analysis to determine if the property can support itself. Don’t base any purchase decision on cap rate alone.

Great post! Dave is right the investor is essentially buying a business for the cash flow because of the market condition appreciation should be considered its just icing on the cake. ARV is more useful for flips and cap rate for buy and hold traditional as a wholesaler this is how my buyer look at it and how we approach buying properties for cash flow.