Newbie MF cashflow question

9 Replies

Hello,

SFH investor here thinking about kicking it up a notch to apartments. Everyone knows the current market is definitely a seller's market, with low cap rates. Been reading that cap rates aren't as important as every newbie thinks, and that a low cap rate property can be a good thing in the long run i.e. "go with quality".

However, my financial calculator is telling me this doesn't work...

For example: A class apt complex, $20m purchase price, 3.5% cap rate ($700,000 NOI), 20% down ($16m note).

At an interest rate of 3.5% over 240 months, the yearly debt service would be $1.11m for a negative cash flow of $413k. For a 360 month term the yearly pmt total would be $862k for a negative CF of $162k.

So how does this work exactly? What am I missing?!?!

@Patrick Sears well that one obviously does not work for cash flow but some investors are buying for longer term appreciation; or turning the whole building into condos, a (foreign) investor might need to launder money, an investor might be trading in a 1031-selling an even worse performer. People buy property for different motivations, sometimes simply because they read it was the thing to do. All the best!

@Patrick Sears

You're not missing anything. If you're property makes 3.5% and you take out a loan at 3.5% interest rate, you're going to have cash flow problem. Taking out a loan to finance a project is based on the concept of leverage. Leverage in this case is borrowing capital to pay for a project where the project makes more than the cost of borrowing. It's usually pointless to borrow money costing 3.5% to pay for a project making 3.5%.

Cheers... Immanuel

3.5% CAP with a 3.5% interest rate. You can stop right there. Fees, interest, term length, etc. will make this negative cash flow. Also risk for any slight capex cost, decrease in occupancy, etc.

Appreciation, and other motives, are a reason to purchase, but I wouldn't buy it if the numbers don't work in terms of cash flow with some conservative underwriting. 

I think for those figures to work you would need to get into 4-5% CAP at bare minimum. Also, others may not be leveraging any debt and satisfied with a 3.5% CAP?

In general you do want to see a spread between your cap rate and interest rate. However, there are interest only loan products that can allow a property to cash flow for several years because the debt service doesn't include pay down of the principal.

In multifamily, many standard or agency lenders aren't going to lend on a cashflow negative property. Look up Debt Service Coverage Ratio. They usually have specific criteria for DSCR ratios which means that the property has to generate enough cashflow to cover the loan.

This article covers cap rate to interest rate spread:

https://www.qreadvisors.com/re...

In single family, the way properties are valued is different (comps). You may come out of pocket $10K per year on a rental property's mortgage but gain $25K through appreciation in certain markets (i.e. California). Personally, if an apartment complex doesn't cash flow, you probably want to look the other way, because that's how apartment complexes are valued--they are valued based on cash flow and rents.

However, there are people who take advantage of a cashflow neutral or negative property (i.e. high vacancy, poor management, down units) that will be purchased as cashflow negative and quickly transitioned to cashflow positive. Typically they will use bridge debt or similar until they can achieve a DSCR high enough to transition to agency debt.

The cap rate of a property IS important, but it's important for new investors not to invest solely based on cap rate. If you are purchasing a property at an 7 Cap in a market where all properties of a similar vintage trade at a 5 Cap, that should cause concern--not be a green light to invest because it's a "better deal." 

Similarly, investing in a random sub-market where properties sell for an 8 Cap instead of a major market where properties trade at a 5 Cap doesn't mean your total return over 10 years will be better if the 8 Cap is in a market with flat or negative rents and the 5 Cap is in a market with 3-5% annual rent growth. 

A Cap Rate is generally used as just another indicator of market sentiment on a particular property's income stream. In some markets, properties will trade at higher Cap Rates because the expected growth rate of rents is very low. In other markets, properties will trade at low cap rates because the expected growth rate of rents is very high.

Additionally, interest rates DO affect cap rates--to an extent. If interest rates were currently at 6%, it would be highly unlikely to see properties sell at a 4.5 Cap. However, interest rates have gone down significantly (as low as 2.7%) which means the spread between your interest rate and cap rate can be as high as 1.8% on a 4.5 cap. 

See Brian Burke's article below for more nuances regarding price at sale: 

https://www.biggerpockets.com/...



Thanks for all the great replies!  So in other words, the math that I use on single family properties is exactly the same as the math you use on apartments, and well, everything else in this universe.  My calculator isn't bullsh*ting me ( although certain "Gurus" on YouTube might be).

I can certainly see buying a property with neg cashflow due to extremely poor management, then turning it around to make it profitable (those are usually the best deals in the end if they pan out), but you wouldn't (or at least shouldn't) be buying those "fixer uppers" at a 3.5% cap.

In my example, I chose a 3.5% loan interest rate.  Since we've determined that cap rate has to be higher than that for the deal to pencil out, what type of spread are you pros looking for? 1.5 points seems pretty skinny unless there is upside in the way of low rents, etc.. I'm not really seeing a whole lot out there in apartments that are listed at >6% cap.

What are you guys buying? Or are you even buying right now?


Well the spread between cap rate and interest rate is not really a good barometer to see whether or not a property will cash flow, there are just too many other variables at play (i.e. term of the loan, loan to value, etc). Pick a metric or metrics that are normally used to evaluate a deal such as CoC, IRR, Equity Multiple. If you're still interested in the spread then you can work backwards from your targeted CoC, IRR, Equity Multiple and figure out the spread, but really, if you're happy with CoC, IRR or Equity Multiple then what does the spread matter?

Cheers... Immanuel

Originally posted by @Patrick Sears :

In my example, I chose a 3.5% loan interest rate.  Since we've determined that cap rate has to be higher than that for the deal to pencil out, what type of spread are you pros looking for? 1.5 points seems pretty skinny unless there is upside in the way of low rents, etc.. I'm not really seeing a whole lot out there in apartments that are listed at >6% cap.

What are you guys buying? Or are you even buying right now?

 

RUN from that deal. Cap rate matters in the perspective of “does this deal make sense given the potential.” A 4% cap rate on a property that can have a huge cash flow increase due to improvements and rent hikes could be much better than a property with a cap rate of 8 but no potential to raise rents or do any value add.

This is where true financial analysis comes into play. What is your loan instrument and the terms? What cash flow will the property deliver and what “could” it deliver aka pro forma calculations. What is the property condition? What is the quality of the tenants and do they take care of the property?

It is an overall picture that drives the decision making process not just one part (cap rate.)