I live in a market with typical cap rates < 3%. Given current 6% plus interest rates and need to secure financing on any property I would purchase, how is it possible to make money? In the case I've described, the NOI will always be less than the annual mortgage payments typically even with 20% down. I'm just getting started and would prefer to purchase small multi-family in my local market, but have no idea how to make it pencil. Any input would be greatly appreciated. Thank you.
Rental Property Investor · Boston, Massachusetts (MA) · Member since 2016 · 2k+ posts · 2k+ votes
4y
@Glenn Driban yup, you nailed it can't really make a financed purchase with that spread work. And with 10 year treasury notes around 3% its less attractive for cash buyers too. Expect cap rates to raise as the interest rates put pressure on prices. Inflation and rents have both risen though
your overall return can include paydown, appreciation, tax benefits etc. so its not impossible but a lot has to go right. And the big cash guys can finance only a percentage, yada yada. For small multi-families you also have the potential to condo.
Cap rates aren't really too useful for small multies (2 and 3s) which still tend to be valued on comps. But 6% is a lot harder than 3-4%, even though its much more in line with historical norms.
@Jonathan R McLaughlin Thanks for the response. At least in my local market the properties do seem valued by cap rate. Some mulit-family listings on loopnet are actually used as STR's and those listings are calculating CAP rate and thus property value using the NOI as STR. From my point of view, that is not necessarily representative of actual CAP rate.
Rental Property Investor · Member since 2018 · 826 posts · 809 votes
4y
@Glenn Driban money is made on appreciation for low cap rate markets. Many people make the mistake of solely looking at Year 1 cash flow to determine whether a deal makes sense.
You'll need to ask yourself first what is your main objective - steady cash flow with higher effort/risk or high wealth generation with lower effort/risk. Markets will equilibrate to investor sentiment based on long term IRRs, not Year 1 cash flow/CoC.
I agree with that we need to wait a while for cap rates to decompress with interest rate changes, but those low cap markets will still have a negative spread vs interest rates.
@Allan C. thank you. I understand the appreciation thing. At the moment not interested in any negative cash flow that would result in financing in my market. I think I’ll have to look for deals elsewhere
are you looking at commercial, or SFH and small multi? cap rates aren't a great metric for smaller stuff even though of course it is possible to calculate them.
how to make it pencil? add value. for big commercial properties you increase rents - cap rate goes up. for small multi and SFH - you add value and boost ARV. this might or might not boost rents (probably will) but it also means you can refi, have more options (keep or sell), etc.
Thank you @Nicholas L.. Small multi family. CAP rates may not be great metric, but I'd good indication of whether you can cover the debt payments. My current issue is that I don't want to be upside down in any significant way on anything I purchase
Turn key provider · San Jose, CA · Member since 2010 · 4k+ posts · 3k+ votes
4y
@Glenn Driban a couple of things pop to mind. First, I don't know where you live but you could very well have to go outside of your local market. If you can't get better than a 3% CAP rate, then I would say you need to consider other markets. You can't pound a square peg in to a round hole. Secondly, why are you fixated on CAP rates if you are financing? At the very least, you should be looking at cash-on-cash return. More importantly though, you want to look at total income and equity return wich includes rquity gain from appreciation and mortgage paydown. One you start evaluating returns in the right way, you'll see that they far exceed any CAP rates you see
Real Estate Agent · San Diego · Member since 2022 · 33 posts · 17 votes
3y
Depends on the market space you are playing in. 2-4 units good luck cash flowing. 5+ units only 1031 exchange money or all cash deals happening. Rates should tick down Q1 next year. Once they get around 5% business will be back. Hit me up if you want to chat more.
Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes
3y
Hi @Glenn Driban! You got some great responses above. This is an era known as "negative leverage." At least for some asset types in some locations.
There are 3 ways I can think of to mitigate this issue:
1. Take on less leverage. 50% debt for example.
2. Quickly grow NOI through raising under-market rents to market levels.
3. Find a steep value-add deal and address it through a very experienced team with a track record for extracting value from under managed and under valued properties.
Note that number 2 and number 3 should be appropriately evaluated through the lens of significant risk and that you may not be successful. You should be prepared in that case to come out of pocket for a long time to pay your debt. Not something I would want to do. That is unless I am investing with an experienced team with a track record to find significantly undervalued deals. Actually, that is what I am currently investing in :) Good luck and happy investing!
Real Estate Broker · Kansas City Metro · Member since 2015 · 2k+ posts · 1k+ votes
3y
Unfortunately the focus is so much on cap rate rather than return on current equity. A 1031 exchange tax deferred into a better cash flowing asset is a win and has nothing to do with cap rate. Happy to chat further to show you the math.
@Alex Olson I totally understand the other components of building wealth in RE, such as appreciation, mortgage pay down, value add... My current issue is that anything in my market without huge down payment is upside down cash flow and I cannot do that at the moment.
Commercial Real Estate Fund Manager · Lynchburg, VA · Member since 2015 · 1k+ posts · 1k+ votes
3y
Hi folks. I commented on this a few weeks ago. I'm curious, since I'm writing about this topic in the BiggerPockets blog...are you investors seeing much movement in cap rates? They inevitably have to expand to keep up the changing interest rate. I'm wondering what you all are seeing?