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Interest Rate and Cap Rate Delta When analyzing Syndication Deal
Hey Guys,
I am trying to get an idea of whether evaluating the delta between interest rate and initial cap rate is a reasonable metric to evaluate when analyzing a syndication deal? For example, if the cap rate is 5.5 and interest rate on loan is 3%, the delta is 2.5. If so what are some target Delta's in different asset classes such as Multi-Family, Self Storage, Mobile home (I have heard a target Delta of 3 is desired in Mobile home class). Does this vary by market, or is this parameter independant of market geography? Id be curious to hear what some target metrics others look for in this delta when analyzing a deal. It goes without saying that this delta allows the deal to have a chance at profitability, so thats why it appears it should provide a value, at least on face value. In addition, the loan terms LTV/LTC I realize effect overall profitability in relation to this delta, but I am trying to keep it simple.
Thanks in advance for your time and answers.
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Unfortunately the economic intricacies of commercial real estate performance foreclose the ability to use rules of thumb and easy tests such as this. Interest rates and cap rates are related, but more like second cousins than twin siblings.
Imagine that interest rates are 3.5% and the property is being bought at a 2.5% cap rate (negative 1% spread). Does that make it a bad deal? What if the rents were 20% below market, market rent growth is expected to be 8% per year, and the expenses are artificially high? That 2.5 cap deal could be a grand slam. Conversely, a 6.5% cap deal might be a dog if there’s no upside from making improvements and negative rent growth is on the horizon (like you are seeing in San Francisco right now).
If a genie were to grant me three wishes I think I just might use one of them to to ask that all real estate investors would immediately stop thinking that the cap rate associated with a real estate purchase means a darn thing. Cap rate is simply a measurement of market sentiment, it has very little to do with investment performance.