Can i have a 5% cap rate Cash Flow better than a 8% Cash Flow?u

Question

Can a 5% cap rate multi family Cash Flow better than an 8% Cap rate ?

Brian Burke · Answer

Cap rate has nothing to do with cash flow.  So the answer to your question is yes, it is absolutely possible for a 5% cap rate deal to cash flow better than a 8% cap rate.

So some might argue, “hey, cap rate is income divided by purchase price so a higher cap rate means more income given the same purchase price so you are all wrong Brian!”

But you didn’t ask about net operating income, you asked about cash flow.  And they are different.

Let’s look at two examples.  a) a 5 cap purchase that is totally mismanaged, has outdated interiors, lacks amenities, and is located in a market with rapid rent growth.  b) An 8 cap purchase that is well-run, all fixed up, has great amenities but is located in a market with declining rents and the agency lenders are not funding new originations in that market.

You could buy property A, finance it with an agency loan, manage it better than the seller, raise rents even without making capital improvements (or make improvements and raise rents even further) and cash flow better than the 8 cap deal.  You could buy property B, you have no room to push rents, you have to use higher-interest rate debt because the agencies aren’t lending there, and your cash flow is less than the 5-cap deal.

Now some people would say that increasing the income of property A causes its cap rate to increase, but that is an incorrect application of cap rate. Cap rate is a measurement of value and is set by the market.  In other words, if similar properties in the market are trading at a 5 cap, the market is a 5-cap and you can estimate the value of your property using the known variable of NOI and cap rate. Increasing the income does not make a 5 cap deal an 8 cap. It’s still a 5 cap deal it’s just worth more now because the income is higher.

This is why cap rate is not a useful way to measure a property’s performance. The only useful function for cap rate is estimating your terminal exit value.

Russell Brazil · Answer

Yes you can. Cap rate is a snap shot in time and does not look at performance over time. Low cap rate properties typically have high rent growth while high cap rates typically have stagnant rent growth.

Cap rate should really be viewed as the risk risk of the asset. Lower cap, lower risk, higher cap higher risk.

Brian Burke · Answer

Not quite.  If the market is a 5-cap market and you buy something at a 7-cap, you've made a great buy and you could just sell it the next day at a 5-cap and make a killing.  The cap rate is a measurement of what the market is willing to pay for an income stream.  You can't change the market cap rate any more than you can change the weather.

You can buy a property and increase it's income after you buy it, and argue that the increased income has increased the cap rate of the property because if you divide the new income by the old purchase price you get a higher number.  People commonly do this as a measure of how they've improved the deal economics, such as "I bought at a 5-cap and by year 3 it was an 8-cap".

But if the market cap rate is still the same as it was when you purchased, you didn't increase the cap rate of your property, you increased its value.

Scott Morongell · Answer

@Jim Growfer many high end operators have already given you sound advice that yes it is possible. As you underwrite 50-100 deals you will learn that the cap rate isn't so much of a concern. What a cap rate does is give you a vague idea of how well you bought. What it does not tell you is what the cashflow will be or opportunity you have to increase the NOI on that asset.

Matt K. · Answer

Why not look at the "value" of the asset and how it performs against your goals.... I can make any single data point be a rockstar or total dog at the click of a mouse. Move past % and generic formulas and look at how it actually performs against your goals (take into account your time line and exit as well).

Leo Poon · Answer

Yes, I agree cap rate is always changing depending on a lot of factors such as tax rate increases, longer vacancy rate, or higher rent. But I think what most people refer to when talking about cap rate is can the 5% cap rate "report card" for the last 12months beat the 8% cap rate "report card". If we are truly considering the future value of a property, then I think using IRR is the better method than cap rate. So Ithe question is are just comparing report cards or are we comparing potential here.

Russell Brazil · Answer

A cap rate is a snapshot in time. It shows you how the property performed over the last 12 months. Also it does not account for capital expenditures. You can purchase 2 properties with different cap rates, but that only shows you how they performed over the last 12 months. It does not tell you how they will perform going forward.

Leo Poon · Answer

@Russell Brazil

@Bjorn Ahlblad

I am confused. The question was if a 5% cap rate cash flow better than 8% cap rate. And to my understanding, the calculation for cap rate is NOI / Asset Price. For example $5k NOI / $100k house price, which is 5%. So how can a $100K property with $8k NOI not producing cash flow if you have taken all the expense into the calculation already?

Leo Poon · Answer

No, cap rate already meant the net cash flow you get after deducting all the expenses. Therefore, 8% cap rate is always higher than a 5% cap rate cash flow considering your talking about the same deal. If your comparing a $100million 5% cap rate deal to a $1million 8% cap rate deal, then the cash flow you receive from the $100million deal is definitely gonna be bigger than the 8% deal because of the principal you invested. It's the same as getting 8% return is higher than 5%.

Todd Dexheimer · Answer

Sure that works as well, but as I said if you are able to execute a well designed business plan, purchasing an underperforming asset can get fantastic. Purchasing an asset at a 3 cap in a 5 cap market could be a great deal if you then can take that asset and raise rents by $200/mo, lower expenses and increase occupancy. You are buying the asset “by the pound”

Can i have a 5% cap rate Cash Flow better than a 8% Cash Flow?u

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