How much cash flow and cap rate is enough?

47 Replies

Need some advice. I'm looking at a 12 unit property that IMHO is overpriced because it breaks even ($0 cash flow) after all expenses and debt service (1.0 DSCR). Cap rate is 5.8% which doesn't seem too bad. I'm trying to figure out an offer/purchase price so my question is, how much cash flow is enough? The lower the price the better the cash flow so at what price and cash flow should I be happy and decide to do the deal?

For example, to get to a 10 cap I would need to pay $410k less than asking which I doubt the seller would go for. Maybe an 8 cap is enough for me which would be about $270k below asking. Should I look at my cost of money and add some margin there to get to an acceptable cap rate? Or are those two numbers not relatable that directly?

Whatever the number is, how do I justify that price/offer to the seller? I don't think sellers care about the 2% rule.

Aside: also having trouble figuring out if there's a going/common cap rate for similar properties in my area. Is talking with commercial brokers the best way to determine that? I could also look at sold properties and what their cap rates are but there aren't many that similar.

Thanks for any advice.

Im sure someone will have a better answer for you but IMO 5.8 cap rate is pretty low. I suppose it all depends on the area you're buying in and if you think you can gain a great deal of appreciation since it only breaks even. 

Also after re-reading, are you factoring in your debt service when you figure out the cap rate? If so, I don't think you should be. 

@David Hanson it's impossible to give an informed response without all the details of the deal. Bottom line: it's up to you...if you are good with the returns then sweet. If your debt service is break-even, that means that you are likely out of pocket for any repairs or capital expenditures...unless this is the only perfect property in the country. 

Aside from that, it's pretty unlikely anyone will lend if the property barely generates enough revenue to pay the note...

By the way, forget everything you learned about the "2% rule"...it's pretty much useless and irrelevant. 

I would say the deal seems a little thin. How is the property currently preforming? Do you have any numbers for us to go off? Personally I would look for a bit of cash flow. If the deal don't meet my standards and the seller won't come down on the price, I'd move on. Don't force a deal.

@David Hanson I believe @Brandon Sturgill is correct. Without all the details and a CMA (Competitive Market Analysis) I don't believe you will be able to make a sound judgment on whether to purchase the property. One way to get more cash flow is by accepting section 8 tenants and making your rental price towards the top of the voucher amount ($2000). Another option is to partner with another investor who has real estate experience, perhaps an agent. Then you'll get free advice, and the amount of money you are risking is cut in half (if you are equal partners).

@Brandon Sturgill exactly, don't know how much return is enough. What cash flow per month on a deal worth between $800k-$900k with a loan of about $700k-$800k is enough? Should I just seek to get enough to get the DSCR To a 1.2 or 1.4, whatever the bank will lend at?

The property is old 1960s and isn't in a large city which makes me want to have more cash flow for repairs, and I don't think there would be much rent growth/forced appreciation. But there is an employment center nearby with decent blue collar jobs so all in all I think rents will be stable and have been says he seller. He's also been raising rents now as tenants turn over so there seems to be a little upside potential there.

I'm looking for cash flow in this next purchase and would prefer $1000-1500 per month but the low price to achieve that may seem extreme to the seller.

@Luke Diem vacancy has been 1-2% says seller so performing pretty well and many of the units were updated about 8 years ago and new roofs on most also. Rents haven't been raised more than $25 in the past 8 years but seems like there's some price sensitivity with tenants in this area because a few have bailed when there was a small price increase.

Problem is his asking price is just too high as I mentioned and I'm definitely not chasing it at current price.

Gotta figure out what to offer and what is "fair".

Given your comments --- why take all that risk for no reward?

If you can lock in a 15 fixed rate, that helps.

I'm an old man, you will go broke if rates go to 10%. Lived through the early 80's.

Just my 2 cents.

@Blake Hansen Thanks for the comments. I would consider taking on an experienced partner and have done so with some other properties but prefer to go on my own for this one except for maybe an equity partner to help with the down payment.

Re: section 8, it doesn't seem morally proper to charge above market rent just because the voucher will pay more, or maybe I need to be more shrewd.

The other thing to note is that this owner will finance the deal himself at 6% (but later adjustable) so not having to get a commercial loan a higher down payment seems beneficial to me (although I haven't yet compared the financing choices apples to apples yet).

@Ed S. Hi, great points and I agree, I do want the cash flow so 1. at the current price it doesn't make sense for me, 2. So I don't mind a longer amortization, 3. I'd like a loan that has at least a 10 year fixed rate to protect against rates going up.

@David Hanson There are a lot of variables involved so it's hard to answer your question.

How much are you putting down? What interest rate over what term can you get on borrowed money? What return could you get on your money if you did something else with it? Are you expecting the property to appreciate or are you after just the cash flow? Are the tax deductions from the depreciation useful to you? How much risk is there of a recession in the next few years? If there is a recession what would your occupancy fall to? Can you find a manager to manage to the cap rate the current owner is getting?

You said:

"Should I look at my cost of money and add some margin there to get to an acceptable cap rate?" Yes for sure but also the opportunity cost of the money you put down. I'm a finance guy and this gets complicated for me when I think about it so let me give you an example where a lot of the variables are constant and the numbers are simple.

Let's assume your purchase price is $1 million, a 6 cap and you can borrow 100% of that at 5 % INTEREST ONLY. Should you do that? Well you have invested nothing and the property pays you $60k per year and your loan costs $50k per year. So you make $10k/year and have no money invested.

At first glance it seems you should do that all day long. Invest nothing and make $10k/year is an infinite return. Do a dozen like that and you can live the good life like the gurus predict.

But hold on, even in this simple example many of those variables could change on you. Let's start with the NOI number because I feel it is the most critical. There are many variables that make up the NOI but let's again simplify a bit.

Let's say you have 12 units that rent for $833.33/month or $10k/year. Total gross rent is $10k/unit per year or $120k total potential gross rent. You experience exactly a 50% expense rate resulting in the $60k NOI we discussed above.

So again we're good and you should do the deal all day long. But look at what happens if you change a few variables for the good or for the bad...

For the good (this is what you will mostly hear about) Raise the rents $100/month or lower the expenses $100/month. NOI is now higher by $100x12 units x 12 months= $14,400. At a 6 cap you just made your property worth $240k more which is an even better infinite return on $0.

But let's talk about the bad for a bit because you won't hear this from the gurus. Here's a few variables on the bad side.

A) 50% is performing well, If you don't have a good, honest  property manager you could easily lose 10-30%  or more while you find one that works

B) Even if you have a good property manager, In all likelihood the previous owner put in tenants that aren't great ahead of the sale. You'll need  to evict 10-30% of them to get a good solid tenant base.

C) You /Your inspector missed a something during due diligence like bad septic tanks/sewer pipes, old trees that need to come down, some legislation that causes you to replace safety equipment, a bad parking area with a spring under it, a leaky roof, a bad boiler.

D) A recession hits and your occupancy/rents drop.

E) Some utilities are being owner paid boosting expenses past 50%.

Again in the interest of keeping things simple let's say one of the above five things drives your NOI DOWN to $40k for the first two years so instead of making $10k each year for the first two years you lose $10k each year. If you have the reserves to cover this you're fine, if not there goes the property.

Keep in mind my financing assumptions are way better than what anyone really uses. You have to put money down or borrow from investors at what 12%?

Sorry for the length of this post but if you've read through it to this point hopefully it is helpful. It is helpful to me to write it out as I try to structure my own deals.

Ask the seller to explain how they reached their purchase price.  If the response is "the agent said it was worth X amount..." then educate them on how to value an income producing property.

Walk away from this deal.  No point in investing in something that doesn't return any money.  Give them your best price - no matter how low it is - and be done with it.

@David Hanson , where is this property located? If it's Seattle, a 5.8% cap is really good. 1.0 DSCR is hard to get. If it's in Maple Valley, you could push a 7% cap. The 2% rule is hard to find in western Washington.

@Jeff Kehl Those are all relevant questions that I'll consider, thanks.  I appreciate the example scenario you've laid out and will help me think through the inputs in a logical way.  I'll probably have a blended cost of money around 5%.

Your warning points A -E are a good checklist, and I have a decent mitigation for some:

A. 50%: I'm considering managing them myself (I already manage 7 properties while working full time) but in case I'm not able to handle the volume I've built into the expenses 10% for professional management and through my network I'll work hard to find a reputable company with good references.

B. Good one.  No mitigation except to budget for the time and expense to evict and change out tenants including any repairs or even cap ex. spend.

C. Definite possibility especially with a 1960s property.  Same mitigation as B but even higher cash reserves needed.  On an ongoing basis I've budgeted for $500 per unit per year in repairs/maintenance.

D. Best mitigation I can think of is to buy at a lower price so any reduction in cash flow doesn't cause it to go negative.

E. I've got a list of the expenses the owner pays vs the tenants (and will verify during due diligence) so that's also all in the expense calculation and unless he's not truthful we're covered there.

I do like assuming a discounted NOI for the first few years too to create a buffer for the bad things happening.

I'm going to try to put down as little as realistically possible aiming for about 10% so maybe a 75/15/10 with the seller carrying 15% and I'm getting a couple quotes for the commercial loan this week, one from my latest broker and another from a community bank that I've dealt with once before.

Hope that all makes sense.

Agreed, @David Lichtenstadter and @Watson Smith , I don't want to do this deal at $0 cash flow because it's too thin and risky and I'm looking for a deal that will cash flow (to supplement my existing properties that are structured as long-term holds).

@Watson Smith, You're last point is new thinking for me recently that list price doesn't have anything to do with what I want to pay for the property and if the seller won't meet me then we walk away. In fact I've done just that on a duplex that we offered on last week where the list is way too high to get a decent cash flow (because the NOI doesn't support the debt service at the list price) so we came in at a number at which we can make good cash flow. Although we can pay more than we offered so I think we were too far below our max because the seller decided not to even counter so this may be a lesson learned to lowball too much. Related to that is the funnel approach that I heard on a podcast recently; consider lots of properties, analyze down to fewer, offer on them, and hope that one gets accepted 1000-->100-->10-->1.

@Ruth Bayang, Property is south of Seattle and like @Blake Hansen suggested maybe I need to get a broker's opinion on the a target cap rate for that area.

We could use an investor meeting in Renton/Kent/Auburn/Maple Valley area ASAP where we can discuss this stuff face-to-face and crowd source deal analyses to help each other. :-)

@David Hanson how long has the property been marketed? If the seller is motivated they'll negotiate price and their seller financing. For the limited details provided, a 5.8% CAP seems fair for South King, but Id need to see more details. 7%-8% CAPs are in Lakewood.

Cap rate = NOI/market value

Un-leveraged ROI = NOI/purchase price (often confused with cap rate)

To determine the proper price and the related downstream returns, you need to determine what similar properties are selling for (i.e. the market cap rate). This is gained by analyzing deals, talking with brokers, following market cap reports from 3rd parties and networking with other investors. It's more art than science for a 12 unit property but this process will get you a reasonable market value range for this property. If you buy wrong in an illiquid or linear market with little value add, it will be challenging to ever recover. I recommend understanding the market first and determining your strategy within that market (i.e. I plan to buy X class properties, X-Y # of units, in these Z markets, with a CoC return of T%, IRR of U%, etc).

Run the figures through your deal analyzer (all the way through your exit of the property) and provide them and your offer (based on them) to the seller.  The numbers speak for themselves.  Some sellers or seller's brokers won't care, others will and, most importantly, you won't care...it's just an objective offer based on your criteria and market data.  Over time, many properties sell at market value and this approach works.  If it is overpriced, the seller and their broker will get that feedback from the market (you and others) and will adjust accordingly or just won't sell.

Unless you are talking agency debt, a 10 year fixed rate loan is not likely.

$500 is on the low end for annual repair estimates for a 1960s 12 unit.  You will want a cap ex estimate in addition to this as well.  Repairs and cap ex will vary widely by property and by investor.

Thanks for the info. It's a FSBO so I don't know how long but would expect the seller to negotiate some as you suggest.

Property is in north Pierce and another one on the MLS is listed at a 7.23 CAP and if my deal was in that range the numbers work pretty well on the buy side.

Seems like CAP rates are a good way to compare properties of this type?

@Mike Dymski Very helpful description, thanks. I wasn't sure how much of the numbers to disclose/share with the seller but I like that perspective, let the numbers talk.

I am concerned about cap ex for things like new windows and other infrastructure items like plumbing, etc. so I suppose I can increase the monthly expense for that to create larger savings for that, over time at least.

@David Hanson for cap ex, many investors create a spreadsheet where they list each building and fixture component, it's estimated remaining life and it's estimated future cost to replace to generate an annual cap ex estimate (and to possibly set aside reserves).  Once again, more art than science but more science than a standard cost (and certainly better than $0).

@Mike Dymski I like the idea of looking specifically at items that will likely need to to be replaced. That cost could be a point of contention with the seller so having hard'ish numbers should help convince him that the expense numbers are reasonable.

@David Hanson in regards to your question on whether CAP rates are a good indicator for comparison properties. Commercial agents (in the Puget Sound region) and investors will use CAP rates, GRM (gross rent multiplier) (sales price/gross annual rents), Price Per Unit, Price Per Sqft, and Cash Flow. Every investor wheighs them differently, and has their preferences. A well marketed property will try to come close to or slightly above these market rates in these categories.

@Pat Riley Good to know various metrics are typically considered and I've looked at/calculated some of those (cap rate, cash flow, $/unit) and will begin to use others too (like GRM). Thx

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