At some point or another, every real estate investor has experienced temptation. You could be the new real estate investor just getting started that gets his head turned by an obscene cash on cash return rate. Or you could be well on your way after purchasing several quality assets and questioning your direction when you see higher cap rates or lower prices elsewhere.
Analytical minds love simplicity. I know because I’m the proud owner of one. We hate ambiguity, it’s “maybes” and “it depend”s. Instead we seek factual benchmarks, hard statistics that show what’s what without a shadow of a doubt. It’s simpler that way: A cap rate of 9 is better than 6 or a cash on cash return of 20 is better than 13.
The problem is long term real estate investing is much more complex than that. When you try to reduce in depth analysis down to the myopic perspective of an indicator or two, it leads to wrong answers.
Ceteris paribus – all else equal – a higher cap rate and cash on cash return is better than a lower one. Thing is, all else is rarely equal. Higher returns on paper typically reflect a higher level of risk. Think about it this way. In order to acquire a property in a great location you will generally have to pay more than if you were to acquire the same in an inferior location. In addition, properties priced lower tend to have lower property taxes, insurance costs and HOA dues. When you pay less to acquire the same income stream, your rate of return on paper increases substantially. So it follows that to get off the chart returns you have to settle for lower asset quality. Since the property “picks” the tenant, that leads to lower quality tenants which leads to higher vacancies and turnover and lower actual returns. Defeats the purpose, doesn’t it?
So when you read that pro forma income and expense statement the question you should ask yourself is: Am I looking at a paper tiger? Because in the end, the only returns that matter are the ones you get to keep.
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