Does this Cash Flow
I have crunched the numbers and I see a negative cash flow,
I would love a 2nd opinion.
Most Popular Reply
This is a good case study of the relationship between cap rate/interest rate spread and how it impacts cash flow (CoC). You offered a scenario where cap rate is 4.13% and another where cap rate is 5.72%. Financing either scenario with 5% loan is just too expensive.
Why would you finance a 4.13% cap rate with a 5% loan? The purpose of leverage is to get a return higher than the cap rate by financing the project at much lower interest rate. Financing a 4.13% cap rate with 5% interest loan is "reverse" leverage where the bank takes a bigger chunk of the return than you do. Using your assumptions, your CoC goes negative at 65% leverage.
In the other scenario of 5.72% cap rate, you would benefit from leverage somewhat but the spread is too thin where at certain debt/cost ratio, CoC would easily go negative on you (i.e. around 88% leverage). What if you need to refinance in 5 years at an even higher rate?
There are parts of the US where I would still look at this project - areas where I'm almost certain there is strong and above average growth of income or above average appreciation or BOTH. But this requires a complete analysis throughout the investment horizon (i.e. IRR analysis). Without the above growth assumptions, I would be overpaying for this investment. You just don't want to overpay - you lose money by overpaying for a crappy property, you also lose money by overpaying for an excellent property.
All the best... Immanuel