Cap rate and Cash on Cash correlation

[Jared Murphy]

Hello,

I'm new to real estate investing and have been analysis a hand full of deals.  From what I've learned so far the cap rate in my area is between 5.5-6%  As I run the numbers on a 38 unit apartment complex with a cap rate of 5.96 and 25% down I am only showing a 6.71% cash on cash return.  This seems like a low return on money into the deal and my question is it typical to see lower cash on cash return with lower cap rates?  

Thanks

Jared

[Immanuel Sibero]

@Jared Murphy

"..is it typical to see lower cash on cash return with lower cap rates?"

No, that's not the relationship between cap rate and CoC. In general terms, cap rate and CoC are the same until the deal is leveraged. That's why many investor would define cap rate as the return you would expect from a deal if you were to pay all cash (i.e. no leverage is used). Once you introduce leverage in a deal then cap rate no longer reflects the eventual return to the investor, CoC does. Leverage is commonly used to increase expected return by borrowing at much lower rate (i.e. lower interest rate) than the cap rate. The larger the difference between cap rate and interest rate the larger the difference between cap rate and CoC will be (i.e. the harder the leverage works). So if you have a deal with 6.0% cap rate and finance it with a loan with 5.0% interest rate then your CoC will suffer (i.e. will be low) because the "leverage" is not working too hard (i.e. the spread between cap rate and interest rate is too small). But take a look at what CoC would be if cap rate was 9.0% and loan interest rate was 4.0%, you would see the effect of a hard working "leverage".

Cheers... Immanuel