Interest Rate and Cap Rate Delta When analyzing Syndication Deal

[Duke Giordano]

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.

[Brian Burke]

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.

[Duke Giordano]

@Brian Burke

Brian,

Thank as always for your reply, much appreciated.

[Aubrey Tatarowicz]

@Duke Giordano Interest rate and cap rate are important parts of underwriting.  You'll definitely want that information when you figure out if a deal makes sense, but @Brian Burke is right, there are no rules of thumb with just those numbers in mind.  There are other expenses and things to keep in mind.

A good way to start would be to get a deal analyzing calculator for underwriting.  A lot of syndicators offer theirs at a fee or some for free and play around with how those numbers affect the bottom line for a given deal.

[Duke Giordano]

Hello All,

It is interesting to revisit this discussion at a very different market than where we were in a year and a half ago when this discussion started. Many of the current deals have interest rates especially taken into consideration those with cops about 5 to 6% with Rates being purchased at 3 to 4% basically indicating negative cash flow. It will be interesting to see over the next 6 to 12 months how operators navigate these waters in particular those who invest in apartments indications with this negative delta between interest rates and cap rates and how to make deals pencil out. I will be curious to see if operator switch to a fixed rate debt, shifting LTV down, or shifting asset classes altogether that might be more cash flow focused.

Curious everyone's thoughts in this current interest rate environment in relation to where cap rates are.  He will also be interesting to see the tug-of-war between the supply and demand dynamics with less housing available versus demand compared with the negative interest rate cap rate Delta as described above and which one will win out.  

[Paul Moore]

Hi @Duke Giordano. First of all, I love what @Brian Burke told you above, great advice.

The issue Brian is putting forth is that if there is significant intrinsic value in a deal and it can be harvested by an expert operator, then mining this intrinsic value can make an apparently slim deal into a fantastic deal. Check out AJ Osborn's July 3rd, 2018 podcast

(AJ Osborn Podcast) about buying a Super K-Mart in Nevada. Note that he said on the podcast that his $7.5 million investment would eventually be worth in the low-$20 millions, if I recall correctly. AJ has turned down offers north of $30 million.

Also note that if there was a rule of thumb, it would need to take into account the LTC (loan-to-cost) ratio. So if someone only borrowed 40% versus someone borrowing 80%, heaven forbid, on a deal, that would play into your analysis. That’s why it’s so important to analyze every deal. Good luck!