Cashflow Doesn't Build Wealth Round 2; How do things look going forward?

71 Replies

After reading the "Cashflow Doesn't Build Wealth" by Shane Pearlman I can see that there are a lot of really passionate opinions on both sides of the fence. There were some really good arguments presented by both sides. I think it's a healthy discussion, with all sides coming away winners in that we all know a little more about alternative strategies.

I could not help noticing though, that many of the arguments being presented tended to deal with past performance. While that's natural, past performance is no guarantee of anything going forward, as we all know.

What I'd like to ask is where do we go from here in this cash flow versus appreciation debate? Rates appear to going nowhere but up so it follows that cap rates will too. Looking forward into a rising rate environment, what does the future hold for the buy-for-appreciation versus cash flow play?

It seems to me that if you purchased an apartment property after the crash and held it until today you were the beneficiary of a historic compression of cap rates due to rates falling to almost zero. The result was a windfall appreciation for doing nothing more than simply holding the property throughout this period.

If however, we look toward rising loan costs and higher cap rates, the potential is real for both a refi bomb that will eat up some or all of your cash flow gains with at the same time, a cap rate expansion that could wipe out any appreciation gains .

So that begs the question of what the correct strategy is going forward?

I'm certainly not a math whizz, but I've put my trusty old HP10bII calculator to work to lay out some scenarios that may help to illustrate my point. I'm enclosing a hypothetical example in a Google doc spreadsheet. Please have a look over my work and tell me if you see any errors in my calculations. You can view/download the spreadsheet here:

https://docs.google.com/spreadsheets/d/1eWquKpM8cd...

Here are my Assumptions:

Market; West Coast (say San Fran )

Cap rate at purchase: 5%

NOI: 200,000

Purchase price: $4 mill

LTV: 65%

Down: $1.4 mil

Finance: 2.6 million

Terms: 5% for 5 year term 25 year amort

NOI Increase 3%/year

NOI end of year 5: 225,101.76

Net cash flow years 1-5: 149,867.16

Principal Reduction years 1-5: 296,915.00

Debt Principal end of year 5: 2,303,085.00

Cap rate at end of year 5: 8%'

Renewal terms: 8% for 5 year term 25 year amort

Exit strategy 1: sell in 5 years

Exit Strategy 2: hold for 10 years with refi in 5 years

Based on above assumptions here is what I see:

Exit Strategy 1

End of Year 5 sell building for 2,813,772.03

Less O/S Debt of 2,303,085.00

Net Profit 510,687.03

Plus 5 Year Cash Flow of ` 149,867

*Principle Reduction (Included) 0

Total Net Proceeds 660,554.19

Less Down Payment 1,400,000.00

Net Loss:  (739,445.81)

* Note-Principal reduction is already included in the reduced O/S debt amount

Exit Strategy 2

End of Year 10 sell building for 3,261,932.96

Less O/S Debt of 2,125,147.00

Net Profit 1,136,785.96

Plus 10 Year Cash Flow of 314,281.00

*Principle Reduction (Included) 0

Total Net Proceeds 1,451,066.82

Less Down Payment 1,400,000.00

Net Gain 51,066.82

* Note-Principal reduction is already included in the reduced O/S debt amount

Given the above scenario, in my view, it does not seem to make any sense to buy now. It makes more sense to hold off on buying until cap rates rise. To illustrate the point, here is a third scenario where I hold off on buying the same building for 5 years as I wait for cap rates to rise.

Same Assumptions with new cap/interest rates/NOI:

Market; West Coast (say San Fran )

Cap rate at purchase: 8%

NOI going in: 225,102

LTV: 65%

Terms: 8% for 5 year term 25 year amort

NOI Increase 3%/year

Purchase price: 2,813,772.03

35% Down 984,820.21

Debt Principal 1,828,951.82

Exit Strategy:

End of Year 5 sell building for 3,261,932.96

Less O/S Debt of 1,802,341.00

Net Profit 1,459,591.96

Plus 5 Year Cash Flow of 326,419.00

Principle Reduction Included 0

Total Net Proceeds 1,786,010.66

Less Down Payment 984,820.21

Net Profit 801,190.45

Given the above cap/rate increase scenario if I were to buy today, and hold for 5 years I could lose my shirt. Otherwise, if I hold for 10 years and then sell, my net profit will be only $51,066.82 for 10 years of work. However if I were to hold off the purchase for 5 years I stand to make a profit of $800,000 for only 5 years work.(versus the $50,000 for 10 years above)

Am I missing something here or does it make no sense to buy right now unless you can be assured that you are directly in the path of a future higher density redevelopment of your property. Even, then, how do you weigh the chances that you will guess the development path correctly versus the risk of a potential loss or no gain if you guess wrong?

I would love to hear everyone's take on the multifamily property investment scenario going forward.

I apologize for the length of my last post. I thought it would be a lot more readable than it turned out to be, but I didn't manage to get it formatted on the page the way I intended to so it all runs together. Sorry about that.

Anyway, I think the spreadsheet illustrates the point clearly so I would love to get everyone's thoughts on this important topic.

I have questioned the same things. I am impressed with your numbers and the effort you have put into analyzing this. I have chosen to invest in smaller properties at higher cap rates because those are still available. I am still buying at 8 - 9 CAPS by buying properties that I can improve. It allows me to build in a lot of equity and feel much safer when  the time comes for the loan to reset in 5 years. That way I know I could still sell at a profit along with the probably 4 years of cash flow. I find they don't make a lot of money that first year while we are transitioning and renovating. I'm not on the West Coast, but I am in the Boston area which also has low cap rates.

Thanks for sharing your strategy Barton. That seems to make sense.

Anyone else care to share? I know that there are some really smart investors in this forum, so I would love to hear how everyone is looking at things going forward. Obviously it's easy if you bought low years ago. What I'm wondering is how people are looking at new investments going forward.

@Chester Transo  

You are looking at cap rates incorrectly. Cap rates reflect the RISK that the market values by paying less for the NOI. Higher cap rates do not mean more profitability. Actually it tends to mean the opposite.

Mortgage rates and value?  I bought at 9% and value tripled in about 2 years.  I bought at 12% and values doubled in 2 years.  I bought at 6.375 and value doubled in two years. 

I PREDICT that when mortgage rates increase a percent or two that values will skyrocket in the short term because people will panic about getting into the market at low rates.  Sure, when rates are double or triple there will be a slowing down of values but then the cycle starts again.

A few people on BP expressed their opinion that you don't make money with 5% cap rate. Those who buy 5% cap are mostly concerned with wealth preservation, not growth. Your 10 year scenario plays well into that idea.

A couple more things:

1.   8% mortgage rate would translate to 6+% rate on 30 yr US Treasures. That's almost twice as much as it is now. Wouldn't it send gov't deficit into the stratosphere? They don't want it so they'll do everything to keep the rates low.

2.  3% rent growth in San Francisco is probably an understatement. It's closer to 10%:

http://www.axiometrics.com/company/pressreleases/n...

Originally posted by @Nick B.:

A few people on BP expressed their opinion that you don't make money with 5% cap rate. Those who buy 5% cap are mostly concerned with wealth preservation, not growth. 

2.  3% rent growth in San Francisco is probably an understatement. It's closer to 10%:

http://www.axiometrics.com/company/pressreleases/n...

1.  Yes I agree that " 

A few people on BP expressed their opinion that you don't make money with 5% cap rate."

An opinion that is not supported by fact. 

2.  "Those who buy 5% cap are mostly concerned with wealth preservation, not growth."

Actually the people I see doing this ARE looking at "upside" (Increasing rents AND value. that's the whole reason they are willing to pay so much for current NOI. Risk is also a part of this.

Originally posted by @Nick B.:

A few people on BP expressed their opinion that you don't make money with 5% cap rate. Those who buy 5% cap are mostly concerned with wealth preservation, not growth. Your 10 year scenario plays well into that idea.

A couple more things:

1.   8% mortgage rate would translate to 6+% rate on 30 yr US Treasures. That's almost twice as much as it is now. Wouldn't it send gov't deficit into the stratosphere? They don't want it so they'll do everything to keep the rates low.

2.  3% rent growth in San Francisco is probably an understatement. It's closer to 10%:

http://www.axiometrics.com/company/pressreleases/n...

Bay Area rent growth has averaged over 14% in the last year. Granted, this is just one year so you can't assume that every year, but it is more than 3% per annum. Keep in mind, NOI growth would be even higher, because property taxes can only go up 2% a year in CA and inflation on other expense categories did not go up 14% either.

http://www.latimes.com/business/realestate/la-fi-rent-growth-picking-up-pace-20140908-story.html

Originally posted by @Bob Bowling:

@Chester Transo 

You are looking at cap rates incorrectly. Cap rates reflect the RISK that the market values by paying less for the NOI. Higher cap rates do not mean more profitability. Actually it tends to mean the opposite.

Mortgage rates and value?  I bought at 9% and value tripled in about 2 years.  I bought at 12% and values doubled in 2 years.  I bought at 6.375 and value doubled in two years. 

I PREDICT that when mortgage rates increase a percent or two that values will skyrocket in the short term because people will panic about getting into the market at low rates.  Sure, when rates are double or triple there will be a slowing down of values but then the cycle starts again.

Hi Bob,

Thanks for the reply. But I'm a bit confused. I don't think I indicated anywhere that I thought that a Cap rate increased profitability. I simply used the cap rate to capitalize the NOI in determining the value of the building. I would appreciate it if you could show me where I said otherwise.

Also, it is my understanding that the opportunity cost of alternative investments plays into what the market is willing to cap a property at. If I can get 5% on my CD at the bank, then I am going to need something more in the way of a Cap to take the risk of owing and managing the building. Thus higher interest rates will drive cap rates up, thereby lowering the future value of my current building, as the spreadsheet I enclosed shows.

Cheers

Originally posted by @Nick B.:

A few people on BP expressed their opinion that you don't make money with 5% cap rate. Those who buy 5% cap are mostly concerned with wealth preservation, not growth. Your 10 year scenario plays well into that idea.

A couple more things:

1.   8% mortgage rate would translate to 6+% rate on 30 yr US Treasures. That's almost twice as much as it is now. Wouldn't it send gov't deficit into the stratosphere? They don't want it so they'll do everything to keep the rates low.

2.  3% rent growth in San Francisco is probably an understatement. It's closer to 10%:

http://www.axiometrics.com/company/pressreleases/n...

 Hi Nick,

Thanks for the reply. You make two very good points. 

On rates, I guess I'm wondering if the Fed has any more ammunition in their arsenal to keep rates down indefinitely. I think we can all agree that when we look at the true inflation rate at the grocery store and gas station we can come to the conclusion that someone may be lying about the official inflation rate. The Fed themselves have a furious debate going on internally about how much longer they can keeps rates so low. I guess I'm wondering when the bondholders are going to rebel and take the decision making process on rates out of the Fed's hands. I hope you are right but I simply want to cover my butt in case you are wrong.

So what do you think would be a more realistic scenario for rates over the next 5 years? 

Also, am I correct that there are rent controls in San Fran?   If so, are you able to get a 10% rent increase even if the demand is there?

I'd be happy to rerun the numbers with a scenario that makes more sense to everyone.

@Chestor T   SAID

"in my view, it does not seem to make any sense to buy now. It makes more sense to hold off on buying until cap rates rise."

Originally posted by @Matt Mason:
Originally posted by @Nick B.:

A few people on BP expressed their opinion that you don't make money with 5% cap rate. Those who buy 5% cap are mostly concerned with wealth preservation, not growth. Your 10 year scenario plays well into that idea.

A couple more things:

1.   8% mortgage rate would translate to 6+% rate on 30 yr US Treasures. That's almost twice as much as it is now. Wouldn't it send gov't deficit into the stratosphere? They don't want it so they'll do everything to keep the rates low.

2.  3% rent growth in San Francisco is probably an understatement. It's closer to 10%:

http://www.axiometrics.com/company/pressreleases/n...

Bay Area rent growth has averaged over 14% in the last year. Granted, this is just one year so you can't assume that every year, but it is more than 3% per annum. Keep in mind, NOI growth would be even higher, because property taxes can only go up 2% a year in CA and inflation on other expense categories did not go up 14% either.

http://www.latimes.com/business/realestate/la-fi-r...

 Hi Matt,

Thanks for the reply.

I choose San Fran as only one possible example of a Westcoast market with low cap rates. I did not intend to get into the specifics of that one market. I was simply trying to come up with a conservative figure for NOI growth that would apply globally in all markets with low cap rates. I am happy to adjust the numbers with whatever scenario everyone thinks makes sense.

For example, looking at another Westcoast market paints a slightly different picture. In the Apartment market in Vancouver, Canada cap rates for properties in the desirable downtown market are going for as low as 2%. In addition, many of these properties have significant deferred maintenance and there are rent controls in that market that limit rent increases to 2% over the official inflation rate which is pegged at 2%.( 4% max increase) So for that market, my example is wildly optimistic.

Getting back to my main points:

What is the group consensus for interest rates and cap rates in 5 years.

How is that affecting each person's investment strategy  going forward.

Under what circumstances are you willing to commit your capital if you are concerned about rising interest and cap rates.

Thanks all

@Chester Transo  

have to say, I didn't look at this carefully enough. Partly, I don't understand the definitions.

As I understand it, your "Net cash" means the net profit/ what you actually put in your pocket that year.

If that understanding is correct, then the first year would be:
Down payment: $1,400,000

Profit: $17,608

So, return is 1.26%?

Hi Chester. I am curious as to why you believe interest rates will rise significantly. Also howwould the FED lose control. The fed is the dog that wags the bondholders tail. There is no bond vigilantes that are going to drive up rates in the US. I believe the vast majority of folks have a misunderstanding of how our monetary system operates. I encourage you to visit pragcap.com to take a look at an alternate understanding that explains all those things that we often feel don't make sense... it took me a couple months of reading daily to finally understand it reasonably well.

Originally posted by @Udayabagya Halim:

@Chester Transo 

have to say, I didn't look at this carefully enough. Partly, I don't understand the definitions.

As I understand it, your "Net cash" means the net profit/ what you actually put in your pocket that year.

If that understanding is correct, then the first year would be:
Down payment: $1,400,000

Profit: $17,608

So, return is 1.26%?

 Hi Udayabagya,

Thanks for the reply.

Yes the net cash would be what you put in your pocket that year buy you would also have to include the 53,610.00 in principal reduction to calculate your return so it would be better than 1.26%. 

Thanks

Originally posted by @Kyle Hipp:

Hi Chester. I am curious as to why you believe interest rates will rise significantly. Also howwould the FED lose control. The fed is the dog that wags the bondholders tail. There is no bond vigilantes that are going to drive up rates in the US. I believe the vast majority of folks have a misunderstanding of how our monetary system operates. I encourage you to visit pragcap.com to take a look at an alternate understanding that explains all those things that we often feel don't make sense... it took me a couple months of reading daily to finally understand it reasonably well.

 Hi Kyle,

I'm not sure that rates will rise significantly. I'm just sure that they can't stay this low forever. But I could be wrong. And I hope I am because it would make forward planning a lot less hazardous.

I looked at pragcap.com, as you suggested, and there is a great article there that goes to your very point. It's entitled "Who Determines Interest Rates?" BY CULLEN ROCHE. In it he says "Bond traders don’t fight the Fed because they know the Fed is the monopoly reserve supplier. You can’t beat the Fed’s printing press. Therefore, “bond vigilantes” in the USA are an overstated risk in general."  

However if you read on, he goes on to say, "In addition, the market rates on other interest rate products are likely to rise in a high inflationary environment even if the Fed were to keep overnight rates low. If a bank can charge you a higher real rate on bank loans because the economy is stronger then the difference between the benchmark rate and the lending rate just makes it more profitable for the banks to issue loans. This could also become inflationary and so the Fed is very likely to respond to a high rate of inflation by raising interest rates. Therefore, the Fed responds to the state of the economy." 

(http://pragcap.com/who-determines-interest-rates)

This speaks more to the scenario that I was speaking of in that it is the relentless creep of inflation that I am concerned about because of all the money that the Fed has printed over the past 5-6 years. There is a ton of cash chasing assets and that has resulted in some of the cap rate compression that we have seen recently. 

And this is what the Fed has been debating internally. How long can they keep rates low before inflation takes hold. Because once Inflation get ahold of an economy, it is hard as hell to stamp out. Remember the stagflation of the Jimmy Carter era and the resulting 15% interest rates that it took to stomp it out?

I'm not saying that is the scenario we are looking at here. I'm just asking how we protect ourselves if rates do move upward. 

When investing for cash flow, it makes sense to only buy at a particular cap rate. But the cap rate can change with a discounted purchase. It isn't necessary to wait until market prices approach the cap rate you desire if you can still find individual deals that meet your criteria.

Originally posted by @Wilson Churchill:

When investing for cash flow, it makes sense to only buy at a particular cap rate. But the cap rate can change with a discounted purchase. It isn't necessary to wait until market prices approach the cap rate you desire if you can still find individual deals that meet your criteria.

 Hi Wilson,

Thanks for the reply.

You make an interesting point. Could you elaborate more maybe with an example, so I can get a better feel for the point that you are making?

Thanks

Originally posted by @Bob Bowling:

@Chestor T   SAID

"in my view, it does not seem to make any sense to buy now. It makes more sense to hold off on buying until cap rates rise."

Right, I see how you came to that conclusion now. I was simply saying that if I wait until cap rates rise I could buy the same NOI for less money. In other words, if the NOI is $200,000 and the cap rate was 5% I would pay $4 mill for the building but if the cap rate was 8%, I would only pay $2.5 million for the same building with the same $200,000 NOI. Therefore, if I was convinced that cap rates were going to rise, I would be better off waiting for cap rates to rise before buying because I would pay $1.5 Mil less for the same building and same NOI.

Hope that clarifies things.

Best wishes

I'm continually amazed at the number of investors buying commercial properties at market rates. In that case, making money is based on elements outside your control (interest rates, market appreciation).

You should never rely on those elements. When the next down cycle hits, you'll get wiped out just like so many did in 2008.

If you buy a property at a discount to the market and then raise it's value to highest and best, with a healthy 25-30% margin, you make money. You can then refinance at 70-75% loan to value and pull some equity out to recover cash. But you still have a conservative debt to equity ratio.

At that point, you no longer care what the market is doing. You're holding a cash flowing asset with good debt coverage and little to no cash tied up.

Who cares about cap rate compression? It's irrelevant. You can employ this approach in any market condition.

Can't find those deals? Ok. Then create them. It's not that hard.

I may have missed something because of the formatting, or because I am dense, tired, or a couple beers into my night. But if we buy @4MM with a 5% cap and an NOI of $200k. Assuming an annual 3% NOI increase:

Y1 NOI - 206,000 @ a 5% Cap Rate means the property is worth 4.12MM

Y2 NOI - 212,180 @ 5% Value = 4.24MM

Y3 NOI - 218,545 @ 5% Value = 4.37MM

Y4 NOI - 225,101 @ 5% Value = 4.5MM

Y5 NOI - 231,854 @ 5% Value = 4.64MM

You have accumulated $640,000 in appreciation only equity in 5yrs.  Somewhere our numbers are off.

Originally posted by @Victor Menasce:

I'm continually amazed at the number of investors buying commercial properties at market rates. In that case, making money is based on elements outside your control (interest rates, market appreciation).

You should never rely on those elements. When the next down cycle hits, you'll get wiped out just like so many did in 2008.

If you buy a property at a discount to the market and then raise it's value to highest and best, with a healthy 25-30% margin, you make money. You can then refinance at 70-75% loan to value and pull some equity out to recover cash. But you still have a conservative debt to equity ratio.

At that point, you no longer care what the market is doing. You're holding a cash flowing asset with good debt coverage and little to no cash tied up.

Who cares about cap rate compression? It's irrelevant. You can employ this approach in any market condition.

Can't find those deals? Ok. Then create them. It's not that hard.

 Hi Victor.

Thanks for your comments. I find them really intriguing. 

What I think I hear you saying is that the best way to protect your capital investment against a potentially unfavorable interest rate move in the future is to buy at enough of discount to market now, and then add enough value to the property, so you can refinance it and pull essentially all of your capital out of the property. I like that a lot.

So then you have few, if any funds at risk and the property is still cash flowing. Then you really don't care what happens in the future because it's all gravy. I love it!

You said that it's easy to create deals like that. I'd appreciate it if you could give some me more insight into how you create these deals, cause all the deals I've been looking at lately suck. There is just too much money out there chasing deals.

Thanks much

Originally posted by @Troy Fisher:

I may have missed something because of the formatting, or because I am dense, tired, or a couple beers into my night. But if we buy @4MM with a 5% cap and an NOI of $200k. Assuming an annual 3% NOI increase:

Y1 NOI - 206,000 @ a 5% Cap Rate means the property is worth 4.12MM

Y2 NOI - 212,180 @ 5% Value = 4.24MM

Y3 NOI - 218,545 @ 5% Value = 4.37MM

Y4 NOI - 225,101 @ 5% Value = 4.5MM

Y5 NOI - 231,854 @ 5% Value = 4.64MM

You have accumulated $640,000 in appreciation only equity in 5yrs.  Somewhere our numbers are off.

 Hi Troy

You are correct that if year 5 NOI was $231,854 capitalized at 5% then the building value in year 5 would indeed be 4.64MM with $640,000 in appreciation profit. The scenario that I was painting however, is one where market cap rates have moved up along with interest rates, so that the cap rate on the sale of the building would be 8%, not 5%. $231,854 capitalized at 8% puts the building value at 2.90MM, so instead of a $640,000 profit you are looking at a loss in value of over 1MM.

Thanks

I agree with @Nick B.  - 8% mortgages are unlikely unless the economy is firing on all cylinders.  And in SF Bay, due to scarcity, equity and rents are going to continue to climb.  This is one of the pockets where the market bubble is rather isolated from realities which exist everywhere else :)

Originally posted by @Ben Leybovich:

I agree with @Nick B.  - 8% mortgages are unlikely unless the economy is firing on all cylinders.  And in SF Bay, due to scarcity, equity and rents are going to continue to climb.  This is one of the pockets where the market bubble is rather isolated from realities which exist everywhere else :)

 Thanks Ben, 

So is the consensus then that there is zero interest rate risk on the horizon that we would need to plan for in our exit strategy in say, 5 years or is there a small but manageable risk, or a larger but manageable risk, etc.

In other words, what do you think is the most likely interest rate and market cap rate scenario 5 years out and what steps can we take to manage any associated risk?

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