Cap Rates at 3%, Interest Rates at 0% (Libor), worth investing?

22 Replies

Syndicates are paying at 3% cap for properties, they are paying interest on the property at 4ish % including buying caps etc.

For cash flows- if your debt is at 4.5% and your cap is at 3%, youre negatively leveraged. So coupons are not going to come to fruition. 

Once the interest rates go up, how is this sustainable for disposition? 

Interest rates go way up, you cant really exit with a good profit?

Someone prove me wrong?

Those who buy 3% cap rates hope to raise rents and NOI for the effective cap rate of 4%+. Then sell to a 4% cap rate buyer.

For example, someone is buying at 3% cap rate with debt of 3.1%+LIBOR. They plan to sell in in 5 years at 4% cap rate. NOI is projected to grow 75%+. If their plan works, investors would double their money.

Inflation is running at 6.2%.

If we were all able to make money borrowing at 6% in a 2% inflation rate, why do you think you wont be able to make money borrowing at 4% with a 6% inflation rate?

Originally posted by @DongHui Patel :

So the only way these make financial sense is if the NOI is showing 75% growth at exit?

Yes. All these investments ONLY make sense if NOI grows and grows fast in the first 2-3 years.

Struggling here - the NOI is forecasted to whatever the syndication wants to proforma it at. So anybody can make it grow to whatever they want it to. Realistically there are other factors which influence this (like interest rates, which obviously cannot go any lower). Holding all else equal to hit a 75% growth on a 5 year exit ASSUMES 12% annualized top line (GPR) increase annually (assuming no optimization on costs, bad debt, vacancy). Seems very aggressive.

Rent growth is not linear because it's a "value-add" deal. It's something like 22% in year 1, 18% in year 2 and 4% thereafter. Aggressive? Yes. But with the market being as crazy as it is they might make it. 

Originally posted by @Russell Brazil :

Inflation is running at 6.2%.

If we were all able to make money borrowing at 6% in a 2% inflation rate, why do you think you wont be able to make money borrowing at 4% with a 6% inflation rate?

So you think inflation will continue at 6.2% every year for the unforeseeable future? THats quite a assumption. 

Logically this is no more than 1-2 years. Look at all historical numbers here. If it goes beyond that we have much bigger problems. 

These are 5-7 year investments. So again, the problem remains, in 5 years what do we do? 

@DongHui Patel

1971 the US money supply increased by 12%. The next 13 years saw inflation rates of 4.29%, 3.27%, 6.18%, 11.05%, 9.14%, 5.74%, 6.50%, 7.63%, 11.25%, 13.55%, 10.33%, 10.33%, 6.13%.

In 2020 the US money supply increased by 35%.

We havnt even hardly started to feel the effects of the money supply increase yet.

Originally posted by @DongHui Patel :
Originally posted by @Russell Brazil:

Inflation is running at 6.2%.

If we were all able to make money borrowing at 6% in a 2% inflation rate, why do you think you wont be able to make money borrowing at 4% with a 6% inflation rate?

So you think inflation will continue at 6.2% every year for the unforeseeable future? THats quite a assumption. 

Logically this is no more than 1-2 years. Look at all historical numbers here. If it goes beyond that we have much bigger problems. 

These are 5-7 year investments. So again, the problem remains, in 5 years what do we do? 

One thing is for sure.... if we have crazy inflation, I don't see how any sponsor will be able to make a successful exit as the cost of financing will go way up.

As for your original question, I see what you're getting at, but I would assume that for a CORE property like the one you are describing, I wouldn't be comfortable if a syndicator intended to finance more than 70% of the purchase. Would prefer something around 65%.

@Nick B. is right--today's pricing is predicated on revenue growth.  Revenue growth isn't tied to interest rates, it's tied to supply and demand in the rental market, plus what other comparable properties are charging.  

Here's an example:  We bought a property last year at around 4% cap.  Rents were about $940.  The deal made sense, because our analysis of comparable properties plus our experience in the market led us to believe that we could achieve $1,090 rents if we made some light renovations to the units.  We were right, we were immediately renting units at the goal rent.  This means that soon our income would be increasing, and thus this "cap rate/interest rate spread" concept was out the window.  If you were to look at our income a year later and recalculate a yield on cost it would offer a really nice spread over our mortgage interest rate.

Fast forward to now--we are actually renting units for around $1,600 (that's not a typo)--which is a 70% increase and we've only owned the property for 12 months.  This is why people are now buying at 3% cap rates...they are seeing the out of control rent growth and they know that the revenue stream is growing--rapidly.

Remember--cap rate has nothing to do with investment performance.  It is simply a thermometer that reads the market temperature.  When the market is hot, cap rates are low because buyers are willing to pay a premium for an income stream, typically on the belief that the income stream they are buying will be larger tomorrow than it is today.  If the market is soft, cap rates go up because buyers aren't willing to pay as much for the income stream, usually because they think that the income stream isn't going to go up much, if at all, or might even go down.  

If you are trying to correlate interest rates and cap rates you're missing the point.  They are related, but more like second cousins, not twins.

At 3% cap rates, every $1 increase in NOI increases the property value by $30 (no typo). Every $50 per month increase in rents is worth $20k increased value per unit.

@Mike Dymski but cap rate is dynamic, and if interest rate increases so will cap rate and the so called Value add diminishes. Also from his post I wasn’t clear whether market cap is 3% or purchase cap is 3% and what the pro forma stabilized cap is.

Originally posted by @Allen L. :

@Mike Dymski but cap rate is dynamic, and if interest rate increases so will cap rate and the so called Value add diminishes. Also from his post I wasn’t clear whether market cap is 3% or purchase cap is 3% and what the pro forma stabilized cap is.

Agreed. Anyone who brushes off interest rate risk and the effects it will have on the cap rate is either in denial or is trying to get you to invest. Interest rate risk is very real, especially right now.....not only from an exit strategy perspective but also if recapitalization is part of the splendid numbers investors get on their proformas.

Thanks @Brian Burke . @Tony Kim , I appreciate your thoughts and share your concern about interest rates rising in the future.

But I wonder how the Feds can afford to raise rates very much due to the cost to the US to pay for its massive debt load. And I wonder if banks will start raising the spread even if the feds don’t raise their rates much? I’d love to hear others’ thoughts on this.

Originally posted by @Paul Moore :


And I wonder if banks will start raising the spread even if the feds don’t raise their rates much? I’d love to hear others’ thoughts on this.

I don’t think that spreads will react because of what the fed does, but if treasuries or LIBOR/SOFR increase I’d be more inclined to expect that lenders would lower spreads. Just like when the indexes went down lenders started increasing their spreads.

Originally posted by @Paul Moore :

Thanks @Brian Burke . @Tony Kim, I appreciate your thoughts and share your concern about interest rates rising in the future.

But I wonder how the Feds can afford to raise rates very much due to the cost to the US to pay for its massive debt load. And I wonder if banks will start raising the spread even if the feds don’t raise their rates much? I’d love to hear others’ thoughts on this.

I think a lot of new things need to fall into place under the "new normal" with which we are currently operating before we can predict anything. Yes, the most recent inflationary report wasn't good, but there are also signs that growth could be slowing and per Yellen inflation should dissipate somewhat next year (her guess is as good as yours or mine though, IMO). I think the dynamics of the labor market will help determine how much interest rates are hiked in the coming few years.

I have worked with institutional sponsors (Starlight, Bridge, Taurus, etc) who might be buying large MF properties at 3 or 4 caps. But they are getting fixed rate debt or floaters (with caps or swaps) at very attractive terms that are typically not available to most non institutional borrowers. Example-80% LTV at 200-250 bps over Libor. Lenders can go upto 80% LTV by having an A/B structure. Loans can be interest only thus boosting cash flow and debt can be structured in a way that there is future funding available for all the capex required. Say, the plan is to invest $20K/unit over the course of 3 years, the lender can fund all of that capex thus reducing the amount of equity needed from the sponsors. Lenders do this as that capex spent is going to raise rents by $200 or 300/unit and that will increase the exit metrics so there is less refinance risk. I dont even need to go into the value add business plan side of things as experienced sponsors' track record speaks for itself but as a banker, hope my comment sheds light on cheap debt is an important part of the overall strategy.

In the last 1.5 years we've exited a number of positions. The average hold period was 25 months, with the longest being 36 months. The average increase in revenue was 47% and ranged from 27% to 77% depending on where in the renovation cycle we sold. The average IRR to partners after all fees and promote was 35% and ranged from 25% to 50%, and the average multiple 1.8x.

Each asset was purchased at 3 Cap or below, and each was sold at a higher Cap Rate by a good margin. 

The benefit of a low cap rate in a value-add situation is the larger lever. If I send $30,000 per unit to lift revenue $650/month and this lift is capitalized at 3 cap, the resulting valuation is $260,000. But, if the same lift is capitalized at 6 cap, the value derivative is $130,000. The math is pretty simple.

@Ben Leybovich makes a great point. The way to overcome the cap and interest rate issues is significant value-add. If you can raise income significantly then he will raise the value proportionally, and the levered equity even more. So a 3% cap rate is not as problematic if you have intrinsic value that can be mined by an expert operator like Ben or @Brian Burke

Originally posted by @Paul Moore :

@Ben Leybovich makes a great point. The way to overcome the cap and interest rate issues is significant value-add. If you can raise income significantly then he will raise the value proportionally, and the levered equity even more. So a 3% cap rate is not as problematic if you have intrinsic value that can be mined by an expert operator like Ben or @Brian Burke

 @Brian Burke - is this basically the way we have to meet now? You could just fly over to Phoenix, you know. Airport next to my house.

Paul, most that is known about real estate is either wrong or misunderstood. It's why guys like us make all the money :)