Is your Cap rate 3% above your cost of capital?

[Jeff Kehl]

I was listening to an Old Capital Podcast today and they had what I thought were some fascinating guests, Vino and Mangesh Patel. They started out investing in hotels in the 80's and switched to B & C value-add apartments in the 2000's. I love interviews with people like this that have been doing this kind of thing for longer than podcasts have been around because I think there's a lot to be learned from their experience.

Vino at one point said that a rule of thumb they followed was that the cap rate of the property they were buying had to be 3%+ above what they were paying for financing. So, for instance if they were paying 5% for capital, they would only look at 8 cap or above properties. 

He also said, for that reason, they stopped buying properties in 2012 and pivoted to developing apartments from the ground up.

Arguably, they missed a lot of upside with that rule. A ton of money has been made on B-C value-add apartments in the 2012-2016 period because of the tremendous demand and rent growth. 

However, I thought it was an excellent reality-check for me specifically because so many of the properties or syndications I look at recently are sooo far from that standard. I looked through one today where the cost of capital was pretty far above the current cap rate. Their profits are all dependent upon getting people to pay more for stainless steel appliances and granite counters. This will continue to work until it doesn't and then I think it will get ugly.

So, to help us BP members, investors and syndicators alike I would like to encourage everyone to look at this metric.

It's a bit hard to calculate because it's not just the amount you are paying on your bank loan but rather that plus the amount owed to the investors on a syndicated deal. If it's your own personal equity it should be the theoretical rate of return you would like but obviously that is less risky.

So my challenge to the BP community is, tell me what these numbers are in your latest deal, be it syndication, partnership or something you just bought. What cap rate did you pay, what was your cost of capital and what was the spread?

[Brian Burke]

I understand what this "rule of thumb" is trying to accomplish, but it's a rule I wouldn't use.  If I did use it, I would be buying nothing.  Let's say rates today are 4% to 4.5%, that means buying multifamily at 7% to 7.5% cap rates.  Most quality product is trading in the 5's and 6's. 

But that doesn't mean that you can't still abide by the spirit of this "rule".  The idea is that your profit is in the spread.  True or not is up for debate.  I'll get to that in a minute, but let's look at some examples first.

I have two deals in escrow right now.  One is bought at a 6% cap with 4% debt.  The second is bought at a 4% cap with 5.6% debt.

My two most recent closings were bought at 5.2% cap with 3.3% debt and 4.7% cap with 3.25% debt.

But all four of these deals are expected to throw off an IRR between 16% and 19% over a ten year hold (higher over a shorter hold). By looking at these numbers you can see that there is no relationship between cap rate / interest rate and the investment returns. There is just so much more that goes into it.

In a value-add deal the business plan is typically to go in and make improvements to the property, which ultimately allows you to capture higher rents.  Even though the application of a cap rate on future income is improper, if you are determined to apply the 3% spread rule, you might find a lot of success if you apply that rule to capitalized income upon stabilization.  But when you do this, don't use your purchase price in calculating this cap rate--use the purchase price plus the cost of your capital improvements. 

For example, on the four deals I mentioned, the cap rate on year 3 income is 7.9%, 8.1%, 8% and 7.3%.  So in all cases but one the spread is greater than 3%, and in that case (using higher-interest bridge debt) we plan to refinance into lower cost debt by year 3 which will then create a spread in excess of 3%.

Unfortunately buying commercial income property (includes multifamily) requires very sophisticated financial analysis and there are no shortcuts or rules of thumb that will give you the complete picture.  When we underwrite deals we never make a decision to buy or not buy (or set a strike price) without thorough underwriting on a very granular level.  Only that level of analysis will give you the measurements that you need to size up the opportunity.