Cap Rate > Interest Rate on Multi-family

24 Replies

I heard from a recent podcast that Cap Rate should exceed interest rate on a multifamily in order to be profitable. What are your thoughts? 

@Ayodeji Kuponiyi

Didn't you get to suffer through my soapbox about CAP rates on an earlier thread?

Your rate of return should ... no, *must* exceed your debt service costs unless you want to be a Greek tragedy.

BTW: your rate of return is the CAP rate if you purchased the property w/o leverage (read: all cash) ... which means there would be no debt service (interest expense), so your CAP exceeding your interest rate would be a certainty.

Interest rate is clearly defined on the note, and in most cases are fixed. While cap rate is anticipated. It would be wise to have a little cushion in case unexpected expenses pop up and lower your cap rate.

It really depends on how levered you are. At standard 70-80% LTV, you'd be crazy to finance w/ an interest rate over the cap rate.

For a mostly cash deal, you could safely borrow a small portion of the purchase price over the cap rate...though I still wouldn't likely do it. 

What really matters for profitability is the delta between blended cost of funds (debt + equity, where true equity = 0*) and cap rate.

* Yes, I know the cost of equity is higher than the cost of debt from a financial analysis perspective, but equity doesn't have a cost on the P&L.

Originally posted by @Ayodeji Kuponiyi :

@Roy N. thanks for the response and I didn't suffer enough lol 

@Chi Cheung thanks for your response

You really need to look into your opportunity cost of capital and your required/expected return.  Using these you set what is often called the hurdle rate for a given project or investment ... which is the minimum rate of return needed before you consider moving forward.   I would also advise discounting your cash flows any time your analysis looks into future performance.

@Roy N.

 Good point, but that's quite a complex way to look at it. 

I think a simpler way to look at it is:

- Interest rate < unleveraged return = positive leverage (good)

- Interest rate > unleveraged return = negative leverage (bad)

Quick lesson on Band of Investment Cap Rate:

LTV x Interest rate = Debt Cost

+

Equity x Equity Yield Desired = Equity Return

Derived Cap Rate

Example:

(80%LTV) x (4.0% Interest Rate) = 3.20%

+ (plus)

(20%equity) x (10% Desired Yield) =         2.00%

Cap rate need to achieve above =             5.20%

Hope that helps.

Originally posted by @Roy N. :

@Ayodeji Kuponiyi

Didn't you get to suffer through my soapbox about CAP rates on an earlier thread?

Your rate of return should ... no, *must* exceed your debt service costs unless you want to be a Greek tragedy.

BTW: your rate of return is the CAP rate if you purchased the property w/o leverage (read: all cash) ... which means there would be no debt service (interest expense), so your CAP exceeding your interest rate would be a certainty.

 Do cap rates consider capital expenditures?

Originally posted by @Nick L. :

@Roy N.

 Good point, but that's quite a complex way to look at it. 

I think a simpler way to look at it is:

- Interest rate < unleveraged return = positive leverage (good)

- Interest rate > unleveraged return = negative leverage (bad)

 Nick:

You have to look at the opportunity cost.   At the moment, our capital is sitting in a low-risk, readily liquid investment which is returning a 5.2% ... or it is sitting in USD money market fund earning squat (I just exchanged a lump this morning and made 22.5% thanks to our oil contaminated Loonie).

As such, when we analyse any "deal" that comes our way, the opportunity cost of that capital is a minimum of 5.2% ... when you adjust for risk, etc. we end-up with a hurdle rate in the range of 6 - 9%.   Surprisingly - or not - there are very few multi-family properties coming to market where the asking price is allowing for a return above 6%.  You must then ask yourself, is all the risk and work required to improve the performance of a {likely overpriced} building (20 - 30 unit, say) worth it for < 1.0% increase in return?

@Frank B.

CAP rates only tell you how much someone was willing to pay for a cash flow.

You could have two buildings side by each with the same CAP rate, same clientele, etc. One could be newly renovated, but not performing due to bad management, the other could be loaded with deferred maintenance and teetering on obsolete, but the owner is milking every last ounce of return out of it .... the CAP rate will not discern. Which one would you prefer?

Granted, the above is an exaggerated and unlikely scenario, but illustrates the simplicity and {one of the} limitations of CAP.

@Roy N.

I totally agree with your point. There's no value in making an investment with an IRR that doesn't compensate you for the work. (The risk should already be built into the IRR, of course.)

I'm just not sure how your point relates to the original question about positive and negative leveraging. What am I missing?

@Nick L.

The original question was whether the CAP rate should exceed interest rate on debt ... which is slightly different than being positively or negatively geared.

Originally posted by @Roy N. :
Originally posted by @Nick L.:

@Roy N.

 Good point, but that's quite a complex way to look at it. 

I think a simpler way to look at it is:

- Interest rate < unleveraged return = positive leverage (good)

- Interest rate > unleveraged return = negative leverage (bad)

 Nick:

You have to look at the opportunity cost.   At the moment, our capital is sitting in a low-risk, readily liquid investment which is returning a 5.2% ... or it is sitting in USD money market fund earning squat (I just exchanged a lump this morning and made 22.5% thanks to our oil contaminated Loonie).

As such, when we analyse any "deal" that comes our way, the opportunity cost of that capital is a minimum of 5.2% ... when you adjust for risk, etc. we end-up with a hurdle rate in the range of 6 - 9%.   Surprisingly - or not - there are very few multi-family properties coming to market where the asking price is allowing for a return above 6%.  You must then ask yourself, is all the risk and work required to improve the performance of a {likely overpriced} building (20 - 30 unit, say) worth it for < 1.0% increase in return?

I would agree. The formula I highlighted is just a simplification of the entire Band of Investment concept. If you want to take it to the max, then each element you highlighted becomes a factor and you then add all together to come up with the cap rate. Google "Band Of Investment" calculations and "Appraisal Theory" to find out more. 

The real message is that each investor should calculate a cap rate applicable to their own investment criteria. Since no two investors would calculate the same NOI, a cap rate is personalized to each investor. Obviously, properties transact in a range and if an investor's criteria is outside that range,he/she may never find a suitable investment. The Band of Investment approach is very helpful in comparing properties that have different strategies if you can comfortably assign a value to each element.

Originally posted by @Frank B. :

 Do cap rates consider capital expenditures?

 Cap rates don't consider capital expenditures. It only considers annual operating expenses. Cap rates tell you about the "flavor" of the certain market, nothing more. You don't buy based on that factor only. It is something like P/E ratio for a stock. 

Does CAP rate have to be greater than Financing rate? Of course not. There are plenty of examples where it would make sense to have higher cost of funds than current cap rate.

Examples such as: Value add property with low current cap rate, short term / mini perm financing with expectation of cap rate improvement over the duration of the financing, 'path of progress' real estate where rental growth rates can reasonably be assumed to increase 'x' percentage over the interim of the financing period, financing a development that will be repurposed, low leverage which offsets financing costs, etc

In addition to the reasons why CAP rate can be lower than financing costs, the math also works out that CAP Rate < Interest Rate can still be profitable.

Example: Suppose you don't have the capital to pay cash for a $1,000,000 property. You use leverage to buy a 7% cap rate with 8% financing with 80% LTV. You pay $74,088 per year for that property in Debt Service on a 25 year AM note. Year 1 return on your cash is 2.96% which is better than many alternatives for your cash (no tax benefits are computed, but those are not insignificant). Assuming a 3% annual growth rate in real estate value (again, not withstanding NOI gains due to management quality) you'll have a loan balance of $738,191 after 5 years and an asset value of $1,161,616. So you have $423,425 in equity on an original investment of $200,000. You will have made 5 years of rent payments (assuming all NOI growth goes to funding capital reserves) of a total of approximately $30,000. So total invested $200,000 total return on investment at 5 year mark is 16.48% compounded annual interest.

In fact the math works out that if given two options of financing:

A) Agency financing at 4% interest, 75% LTV

or

B) Portfolio Lender at 5.5% interest, 80% LTV

With Option A your RoR after 5 years is 21.39% vs. 20.08% for the portfolio financing. The longer you hold the property the better the Agency financing is, but for holding periods 5 years and under it's a wash (with holding periods of 3 years or so better with Portfolio Financing).

The bottom line is that it's better to get the deal going than quibble over the terms, ESPECIALLY if the deal is a value add property for some reason.

Too many investors step over dollars to pick up pennies.

I think people still get confused thinking cap rate relates to or equates to income total (ROI). Cap rate is only evaluating the building as a business independent of personal financial situation or condition.

Obviously if your NOI is $30K and your total expenses are $32K. You cannot earn money safely other than depend on appreciation and loan pay down over the years while operating at a negative cash flow. Simply not a good idea.

This is why total no cash down usually will not make sense because you will simply owe too much. There are a few opportunities to find buildings in locations where rents are really great compared to your total cost to purchase and or repair, plus all other expense but that will be very unusual. 

I see people here all the time find a 10% cap building and think Ah huh! I found a good deal then they proceed to find a HML for their 20% down and figure to get 80% owner finance. No money down, WOW ! Wait, add up all your monthly expenses especially debt service then subtract that from your NOI. Oh !!!!!!!!!!!!!!!!

Example: A building is for sale at $320,000.00 NOI is $32,000.00

$32,000.00/$320,000.00 = 10% cap, right

So Mr. Clever investor figures he's found a good building to buy because it has a 10% cap

but he is figuring he will borrow a HML of $84,000.00 to put a down payment down then he will get an owner financing deal for the remainder, $236,000.00. No money down, how wonderful. However,

The building's cap rate: is 10% but once you add all the expenses including debt service, total = $36,000.00 oh !!!!!!!!!! what's wrong with this picture?

Originally posted by @Gilbert Dominguez :

I think people still get confused thinking cap rate relates to or equates to income total (ROI). Cap rate is only evaluating the building as a business independent of personal financial situation or condition.

Obviously if your NOI is $30K and your total expenses are $32K. You cannot earn money safely other than depend on appreciation and loan pay down over the years while operating at a negative cash flow. Simply not a good idea.

This is why total no cash down usually will not make sense because you will simply owe too much. There are a few opportunities to find buildings in locations where rents are really great compared to your total cost to purchase and or repair, plus all other expense but that will be very unusual. 

I see people here all the time find a 10% cap building and think Ah huh! I found a good deal then they proceed to find a HML for their 20% down and figure to get 80% owner finance. No money down, WOW ! Wait, add up all your monthly expenses especially debt service then subtract that from your NOI. Oh !!!!!!!!!!!!!!!!

Example: A building is for sale at $320,000.00 NOI is $32,000.00

$32,000.00/$320,000.00 = 10% cap, right

So Mr. Clever investor figures he's found a good building to buy because it has a 10% cap

but he is figuring he will borrow a HML of $84,000.00 to put a down payment down then he will get an owner financing deal for the remainder, $236,000.00. No money down, how wonderful. However,

The building's cap rate: is 10% but once you add all the expenses including debt service, total = $36,000.00 oh !!!!!!!!!! what's wrong with this picture?

I actually disagree with this statement. Your rate of return with a zero cash down deal is even greater, even if you have a negative cash flow for the property.

Don't confuse a property being over levered vs. a borrower being over levered. Using your example of a $320,000 property with a negative $4000 a year cash flow. If it appreciates 3% a year, you'll have a property worth 370,967 in 5 years. So without any principle reduction at all, and including the $20,000 in carrying costs for the five years, you'll have made $30,000 with 0 cash initially invested. That's a fantastic cash on cash return. Or you could calculate it as having 50,967 in FV on a PV of 0 and a PMT of -4000 with an N of 5 years = 48% rate of return per year. Not exactly a bad deal at all.

I did mention you could go this way by waiting for appreciation. This is a good thing if in fact you experience the so called appreciation. Its just generally not a good idea to depend on something that may never happen or how about if the market actually drops?

Wishful thinking has generally sunken for folks than I care to think about. 

You know the saying high risks = high rewards

Low risks = low rewards

If you want to be a high roller then roll the dice but for the most part and for most people it is generally more prudent to have a risk management strategy in place. 

You are implying that infant returns are reliable and operating at negative cash flow is just something to ," never mind" what if in your 3rd year of owning this property you loss 30% of your renters, a strong wind blows the roof off of your building? Your carrying cost jumps from  $20K to $300K?

If what you say is reliable we would all be millionaires and real estate investing would be perceived as a risk free investment . Possible? maybe. Reliable ? No. 

There are certain times and certain markets where appreciation happens but do not count on it. Everything looks good on paper. Heck on paper I have become a billionaire and all my deals 100% have been fantastic. 

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Originally posted by @Ayodeji Kuponiyi :

I heard from a recent podcast that Cap Rate should exceed interest rate on a multifamily in order to be profitable. What are your thoughts? 

Cap rate is only useful for underwriting your exit. You underwrite income for each year that you will own the property and using cap rate you can forecast your sale price for any given exit point. It has no place in determining your acquisition price aside from how your exit price coupled with current cash flow effects your IRR at any given purchase price.

That said, your financing rate is only relevant to your strategy, which makes it impossible for anyone on this forum to answer your question given what was asked. You didn't say what the strategy is.

For example, if you bought a property where you forecasted stabilized income to be less than your debt service and you intend to keep the property for a while, you are setting yourself up for disaster. Appreciation, as some have suggested can produce a desirable profit despite negative cash flow, might not be there you to bail you out--just ask anyone that tried this strategy in 2006.  In the buy/hold context I agree with the generalization that your loan interest rate should be lower than your stabilized cap rate. The word "stabilized" is important here. 

On the other hand, I bought a 54 unit building that was 50% +/- occupied, had low rents, and needed major rehab. My trailing cap rate was probably negative upon closing. I financed it with a loan at 12.5% (it was all that was out there at the time when the market was "scary"). Even the stabilized cap rate was less that 12.5% but the financing was around 50% to value by the time the renovation was complete so cash flow was positive. I sold the property 22 months after acquiring it, nearly doubling my investor's money, yielding a 42% IRR. I did not rely on appreciation, I relied on execution of a specific repositioning plan.

So you can see, there is no blanket answer. Evaluating Multifamily property is a complex analytical process with a lot of variables so generalizations are difficult to apply.

I do not think the question was directed to a building you would buy as a value add where appreciation might be up to 50% within the first 2 years and so would cap rate and cash on cash evolve greatly but to buildings that are being sold with no more then a 20% growth potential and appreciation is not expected to be much more than 4% per year or so. We are talking about two very distinct scenarios but it was good you gave the example of how you would consider cap rate and interest expense toward deeply discounted buildings. 

To me the question really has to do with a couple of separate concepts.

The first being property leverage vs. borrower leverage. A borrower must maintain the proper liquidity and cash flow to service debts, so leverage has to be managed. A property on the other hand, if owned by a properly levered borrower, can be levered to the hilt and still be a great deal.

The next concept that I think bears discussion is this notion of 'don't bank on appreciation' and reference to 2008's property crash. The fact is that 2008 was an anomaly and should be considered as such. If you were explaining a trend that for the last 100 years achieved an average increase of property value of roughly the rate of inflation. When you consider a long term trend, it's absolutely reasonable to expect that trend to continue if the underlying fundamental basis for the trend is sustainable. Real Estate (and all real assets) have a history of approximating the inflation rate, and that's a sustainable trend. So to think say that 'you can't bank on appreciation' of real assets is the unreasonable assumption not the other way around.

Business cycles matter but most of the 'value' of real assets is the fact that with a long enough hold time, they appreciate. The question is then what is the proper leverage of the borrower to allow for a long enough hold time. It's not a question of the leverage on the asset, that's a function of the borrower's capital reserves and the cost of the leverage.

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