All Forum Posts by: Arthur Schwartz

Cap rate is the same no matter cash only or debt only.

 Cap rate.  Net operating income divided by price.  Since interest expense is not part of Net operating income.   How you finance has no impact on Cap Rate.

Couple items to consider.

1. Capex needed. Exact same property, exact same NOI and Cap rate. Exact same financing. Which one would you pick? The one with zero or $100,000 capex requirements?

2. Cap rate- who gave you the NOI and the price? Did you validate. Let's say a Cap rate of 6. I can make it legally swing from 4 up to an 8. Plus their list price isn't necessarily your purchase price.

3. Cap rate- their cap rate isn't necessarily your cap rate with your business model. You might pay higher than it's worth knowing you're going to make more NOI with a different business model.

I would throw out the use of cap rate.  As mentioned above go with cash on cash type of measures.  

@Arthur Schwartz yes if the interest rate is higher than the cap rate, the more you borrow the lower your return.  Personally I think it is downright stupid to buy at a cap rate below the interest rate. It is an indication the market has gone to far. 

Yes there are exceptions as @Henry Clark points out. Also if you are buying a property to reposition and increase the rents and value, it might make sense to take on that short term cost and risk. 

The bottom line is; your thinking is correct. Sadly many new investors don't understand the basic math and it can lead to bad decisions. 

@Arthur Schwartz, what Ned said.

There are reasons people would borrow at a higher interest rate than the going-in cap rate.

But both theoretically, and practically, if your interest expense is higher than your NOI, you then you are losing money. While, you might be cash flowing, as Brandon noted, your return will be LESS than if you simply bought cash.

I.e. 6% going in cap, NOI stays flat for your entire hold. Borrowing interest only at 7%

If you buy cash, you will earn 6% on your capital invested.
If you buy 50% LTV, you earn 5% on your invested equity.
If you buy 80% LTV, you earn 2% on your invested equity.
If you buy 20% LTV, you earn 5.75% on your invested equity

The math is pretty simple: if it costs your more to borrow than your current yield, you are diluting your returns by having ANY debt on the property, even if you are cashflow positive.

There might be real world reasons why you would buy a deal with negative leverage, but from a purely financial standpoint, you are always hurting your cash flow by borrowing at a rate higher than your in-place cap rate.