Hello,

I'm new to real estate investing and have been analysis a hand full of deals.  From what I've learned so far the cap rate in my area is between 5.5-6%  As I run the numbers on a 38 unit apartment complex with a cap rate of 5.96 and 25% down I am only showing a 6.71% cash on cash return.  This seems like a low return on money into the deal and my question is it typical to see lower cash on cash return with lower cap rates?  

Thanks

Jared

Yes, it is, @Jared Murphy . Cash flow is a function of NOI minus CapEx and Debt Service. A lower Cap Rate means higher Debt Service due to a higher price. The goal is to find ways to improve your NOI through improving revenue and decreasing expenses.

Thanks, @Jaysen Medhurst   So would it be safe to assume that investors in the area would be accustom to lower cash on cash return on their investment because of the lower cap rate?  

Yes, @Jared Murphy . The lower cap rates reflect both lower inherent risk and an expectation of higher appreciation.

@Jared Murphy

"..is it typical to see lower cash on cash return with lower cap rates?"

No, that's not the relationship between cap rate and CoC. In general terms, cap rate and CoC are the same until the deal is leveraged. That's why many investor would define cap rate as the return you would expect from a deal if you were to pay all cash (i.e. no leverage is used). Once you introduce leverage in a deal then cap rate no longer reflects the eventual return to the investor, CoC does. Leverage is commonly used to increase expected return by borrowing at much lower rate (i.e. lower interest rate) than the cap rate. The larger the difference between cap rate and interest rate the larger the difference between cap rate and CoC will be (i.e. the harder the leverage works). So if you have a deal with 6.0% cap rate and finance it with a loan with 5.0% interest rate then your CoC will suffer (i.e. will be low) because the "leverage" is not working too hard (i.e. the spread between cap rate and interest rate is too small). But take a look at what CoC would be if cap rate was 9.0% and loan interest rate was 4.0%, you would see the effect of a hard working "leverage".

Cheers... Immanuel

@Brian Burke said something very insightful at a conference I attended recently. If I may paraphrase from memory, "People confuse cap rates for a measurement of investment performance."

Your strategy needs to be more detailed than a straight up cash flow play if you're buying for cash flow at a 5 cap. You need to raise rents, lower expenses, or otherwise increase the NOI. Cap rate is a component of your performance because it's the earnings multiple you're paying for the property, but it should not be the only factor informing your return along with your debt service.

Thank you so much @Immanuel Sibero and @Taylor L. the insight from both of you is very helpful!  

Taylor, yes, of course, increasing the NOI is a part of the strategy. I was running numbers on a larger apartment complex and with the higher prices/low cap in my area, I was struggling to get good cash on cash return for the investors (5.5-6.5%). Do you have any suggestions on other factors I should be considering when evaluating the return on investor's money in a low cap rate area?

Originally posted by @Jared Murphy :

Thank you so much @Immanuel Sibero and @Taylor L. the insight from both of you is very helpful!  

Taylor, yes, of course, increasing the NOI is a part of the strategy. I was running numbers on a larger apartment complex and with the higher prices/low cap in my area, I was struggling to get good cash on cash return for the investors (5.5-6.5%). Do you have any suggestions on other factors I should be considering when evaluating the return on investor's money in a low cap rate area?

Don't force the numbers to work. No deal is better than a bad deal. If you're honestly and judiciously underwriting and can't project a decent return for your investors then it's time to move on to the next property. It's important to resist the temptation to do a bad deal just to do a deal! 

It's possible you're being overly conservative, in which case you might want to consider doing an underwriting workshop or education course from an experienced multifamily sponsor. There are many options out there right now and it would be smart to do! 

What happens when you raise lower the LTV to 70%? Does your CoC go up? If you are in a highly appreciative market then that deal seems like it does the trick to me. The fact your CoC is over the cost of financing (about 4% today) means you are properly using leverage. I am curious how you determined the expenses though since usually the OM's down play the numbers and its not until underwriting where you would realize it. You are using a 30 year AM right?

Taylor, thanks that's a very good reminder. The reason I'm asking is not specifically this one deal. I have run preliminary analysis on several properties from small (duplex/fourplex) to large (38 unit apartment) and I keep running into low cap rate, large down payments and low CoC. This made me wonder why and if that is just a function of low cap rate markets/areas or if I was missing something.

My strategy would be to hold the property, increase the NOI as soon as possible thus increasing the value capable of a refinance to pull the investor's initial money back out of the deal leaving them with equity shares of the properties cash flow. The only hiccup I see is a low CoC on the investor's initial cash investment until the property is able to be refinanced.

Cory, when I change to an LTV of 70% my CoC goes down. Going from a 1 million down payment to 1.2 million down payment would add $200,000 more initial money invested but only decrease the yearly mortgage payment by $11,237. To calculate CoC you take the annual cash flow divided by the initial amount of money invested, right or am I missing something?

I used the expense numbers from the 7-year hold projection as they were closer to the previous year's actual.  I also used a higher vacancy rate than shown in the Pro Forma and added additional expenses for CapX and Administrative fees making total expenses 40% of the EGI. Yes using a 30-year loan

Originally posted by @Jared Murphy :

Taylor, thanks that's a very good reminder. The reason I'm asking is not specifically this one deal. I have run preliminary analysis on several properties from small (duplex/fourplex) to large (38 unit apartment) and I keep running into low cap rate, large down payments and low CoC. This made me wonder why and if that is just a function of low cap rate markets/areas or if I was missing something.

My strategy would be to hold the property, increase the NOI as soon as possible thus increasing the value capable of a refinance to pull the investor's initial money back out of the deal leaving them with equity shares of the properties cash flow. The only hiccup I see is a low CoC on the investor's initial cash investment until the property is able to be refinanced.

How large of a down payment? If you put a large percentage down it's going to negatively impact your percentage return. Most multifamily deals have low cash flow early on until the value add is started and rehab is largely complete. Perhaps also consider an earlier sale scenario and see how that impacts your investor returns.

@Jared Murphy unfortunately what you are seeing in today's market is that cap rates have compressed to where they don't make sense for most investors. That is unless there is a clear play to build NOI through higher rents and lower expenses.

Right now cap rates are low which means prices are high. I believe the cap rates today do not reflect the risk in today's market.