Hello, maybe someone can make this more clear for me. I used to think that as long as the interest rate of an mortgage is less than the cap rate of the investment, the investor is guaranteed to make positive cash flow every month and end up with a cash-on-cash return which is greater than the cap rate. However, working through the numbers for a few potential deals, this does not appear to be true.
For example, I was looking at the property for which the price is $1,100,000. According to my estimates, this would result in a gross profit (cash flow before mortgage payment) of about $65,000 per year, which is just over $5,400 per month. So the cap rate is 5.9%. Now, taking a loan with 5% interest rate, 15 year amortization and 20% down, the monthly payment comes to about $6,950.
In the above example, since the cap rate is greater than the interest rate, my thinking was that I will make some positive cash flow in the end, and that the cash-on-cash (with 20% down in this case) will be higher than the cap rate (which is basically 100% down). But of course, this is not correct, as the numbers above prove.
My question is, is my understanding completely off the line, or am I missing something small? Is there any relationship between the cap rate and the interest rate at all which will quickly tell me if the investment is cash flow positive? I mean something intuitive, without having to do the whole calculation.
@Pinaki M. Unfortunately it's not so simple. First of all, your financing structure of paying off a loan in 15 years at a 5% interest rate is pretty brutal. I would recommend looking into either a longer term loan such as 30 years or an adjustable rate mortgage (ARM). Changing that will definitely help. The other side of that equation is the 5% interest. Hopefully you can get that down to below 5% and closer to floating around low 4's if not in the 3's.
If your concern is positive cash flow, you are typically less concerned about when you pay off your debt because the goal is the positive cash flow. Unless you have an interest only loan, you will inevitably begin to pay off your debt.
Not trying to twist the knife once it's already in here, but you also aren't accounting for other expenditures such as taxes, insurance, vacancy and any other ongoing maintenance. There is some amount of positive that you need to have in order to be prepared for some bigger expenses such as replacing a roof, water heater or a re-pipe or just new toilets in general. When your margins are so thin, it's easy to become the slumlord who doesn't want to do anything because you don't have the extra capital to do anything. Then your property becomes neglected and a pain and you end up selling to someone who knows how to run a tighter ship and knows how to get your asset to perform properly. When it comes to this side of the equation, there is no right or wrong way to run your numbers or to prepare for a rainy day. When it comes to property management though, I'd pay the business first before paying yourself or what have you. Tough to look at your super cool wave runner that you can't sell for half of what you paid for it when your tenants are calling saying that their water heater busted and you don't have any cash in the bank.
Long winded, but hopefully it helps and makes sense.
Cap rate is designed to be a valuation metric which has little to do with interest rate. However many investors insist on using cap rate as a performance metric (i.e. measure of income/return). As a performance metric, there certainly is a relationship between cap rate and interest rate since interest rate does affect performance of the investment.
Using cap rate as a performance metric, I think your understanding of the dynamics between cap rate, interest rate (i.e. cost of capital) and cash-on-cash is generally correct. As a matter of fact, you have just described the principles of leverage. What is not always true, however, is your statement - "as long as the interest rate of an mortgage is less than the cap rate of the investment, the investor is guaranteed to make positive cash flow..."
From the formula, we know that cap rate starts with NOI (i.e. revenues minus all operating expenses). To get to cash flow you would normally pay out loan interest, loan repayment, and capital expenditures. This notion of "guaranteed" positive cash flow is only good when you pay out loan interest only (i.e. cost of capital) beyond NOI. In this case, YES you will always cash flow because you take in 5.9% and you pay out 5.0%. As soon as you make additional payments beyond loan interest (i.e. loan repayment, capital expenditures) then there is no guarantee you will have positive cashflow.
So the quick rules of thumb for guaranteed positive cash flow are:
- cap rate is greater than interest rate (you've got this)
- the difference between cap rate and interest rate should be large enough to produce cashflow to cover loan repayment/amortization and capital expenditure plus some amount left over for the investor.
- if you're in a deal where you're financing with interest-only loan payment and there is no capital expenditures, then YES cap rate being higher than interest rate would very likely produce positive cash flow.
Thank you very much for explaining this so clearly! The "loan repayment" is the part I was missing, as you rightly pointed out. In fact, I did think that it could be the "capital" part of the payment that is making the difference, but wasn't completely sure (regarding CapEx, my analysis already took that into account while coming up with the cap rate estimate).
This is a very fundamental concept to understand clearly if one is investing, yet I wasn't getting it quite right, so it had been bugging me for a while. I can sleep peacefully now :) Thanks again!
Umm.. sorry to say but your post is a bit off-topic. Btw, where can I get a commercial mortgage at below 4% interest rate with 30 year amortization? I will be genuinely thankful if you can share that info. I agree with you that life will be much simpler if that was possible :)
@Pinaki M. I think you've received some good answers so far but I think the biggest issue always sits with constructing the cap-rate to begin with. When you're looking at a "whole calculation" you'll find that 90% of the effort is in constructing the cap-rate. If utilities are individually metered, if there's deferred maintenance, etc. all of the way down to what you think it will cost for quarterly pest control. Not to mention (since you're in Little Rock) how you look at economic vacancy between, let's say the River Market and something off of Mabelvale Pike.
What's more material for you (and something that's fairly constant) is the amortization table that your lender will use. If you've been calling around you probably have some sense of if you'll be stuck with a 15 year schedule or if you can get a 20 or 25 year schedule. Those matter far more than 5% vs. 5.125%. Either way, once you know you can whip up a table in 10 minutes that shows monthly debt service for $600K through $1M in staggered $100K blocks.
@Pinaki M. you're right in that my post isn't terribly relevant for commercial in contrast to what you can get for residential income for less than 5 units. That being said, you should definitely be able to amortize over 30 years or go with a different type of loan entirely such as an adjustable rate mortgage instead.
I understand how you might think my comment might be a bit off topic, but if your target is to achieve cash flow, structuring your loan for the greatest success will make or break your cap rate. Correct me if I'm wrong, but your mortgage payment will be your largest expense and it is on-going until you pay it off. Outside of taxes, it will likely be one of your most predictable number when calculating your ROI or Cap rate. It's why I emphasize getting that right before considering the other elements of the equation.
The latter part of my post are the elements that I feel like most people forget to calculate when calculating their cap rate or ROI and it's the direct result of many investors end up not succeeding and not making any money.
If you are looking to get in touch with a commercial lender in California I can definitely help. Unfortunately for you, I can't say that I know anyone licensed to do commercial loans in Arkansas. If you can't find someone on the site, I recommend running numbers on trulia and seeing what pops up there.
If your borrowing money then you should be evaluating the deal based on levered IRR. Cap rates can be used for an estimate for selling the property when you get out of a deal, but if you truly want to know what your yield is you need to base it off of your internal rate of return (ie the interest rate your equity investment is paying you)
Cap rate I use it as an initial “go/no-go” on a property but I would not buy a property based just off a cap rate
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