Can a 3.8% Cap rate (before financing) work?

Question

How do I make this work?

4-unit apartment complex

$1.8 million purchase price

$9,000 combined monthly rent (very close to market rate, minimal value-add through rent increases)

$40,000 operating expenses (taxes, insurance, capex/vacancy savings).

Tenants already pay utilities.

3.8% cap rate BEFORE financing. All numbers are market-rate, property is nicely updated.

Is this a "cash-or-bust" deal, only? I dont have $2 million, but I can do 5-20% down. Problem is... a mortgage makes the deal $3,000+ negative... monthly!

Please share your most creative ideas. I'm looking for a multifamily to potentially house a family member's family in one unit. Prices are not affordable to the lower (economic) working class in this area (Bay Area, California) and me owning a property would help the family member maintain an affordable living quarters.

Thanks in advance!

Taylor L. · Answer

Cap rate never factors in financing. I don't think it works. Normally when investors are seeking yield and buying low cap rate deals, the plan is to add value in order to achieve the return. As you've said, this doesn't have much value add potential. Since it's a 4-unit, the value of this property isn't even based on the NOI anyway.

I wouldn't even say cash works. If you buy it cash you're getting a pretty lousy return on equity.

I wouldn't even say cash works. If you buy it cash you're getting a pretty lousy return on equity.

Scott Wolf · Answer

@Vincent Roache, it doesn't work.  Move on to the next one.

Ned Carey · Answer

@Vincent Roache if it is a 3.8% cap rate and borrowing rate are 4-5.5% that doesn't make sense to finance. The more you borrow the more you lose.

5-20% down is not very much. Most lenders want 25% down although 80% financing is available.

The best way to make this work is walk away, and use the time looking for a deal that works.

Kushaal Malde · Answer

@Vincent R. does your $40k in Operating expenses include the Property tax being reassessed at the purchase price value? A conservative estimate would be 1.5% of $1.8m or $27k per year, leaving you with a budget of $13k for all other expenses per year.

Nick Belsky · Answer

@Vincent R.

I'd need to see a breakdown of what is included in Operating Expenses.  Often we don't use everything that people put in there.  If it is accurate, either one of two things needs to happen; you put a whole lot more down on it or they come down on price.

If you are seeing a $3k loss, then this is not a good deal... walk away.

Cheers!

Brian Ellis · Answer

Cap rate usually fluctuates as follows:

Lower cap rate = nicer area

Higher cap rate = crappier area

But either way you want value add.

But you shouldn’t be looking at this from a cap rate standpoint. It’s a 4 unit building. Cashflow and your return on investment is what you should be looking at.

Allan C. · Answer

@Vincent Roache be cautious taking advice from any non-CA investors. The CA market is a 2-3 cap market period, and it’s because the investors here have deep pockets. You’ll need a long term strategy (either value add or having sufficient reserves to carry early year negative cash flow).

However, once you break-even on cash flow after ~5 years, you’ll likely experience an acceleration of positive cash flow. The investors out here do rely on appreciation, but these same investors are often preserving and growing wealth instead of trying to obtain wealth.

Keep in mind your largest expense is property tax, and there’s a fixed amount it increases. Assuming market preserves value, you fix a lower tax basis than anyone else purchasing rentals in the future. That works to your advantage.

Jon Kelly · Answer

@Vincent Roache You can make this work in cases:

1. If you buy it for $1.2M

2. You're taxable income is over $1M. With this income you can absorb the $3k/mo loss and reduce your taxable income. You're losing $36k/year but "saving" $18k in taxes. All while hoping for appreciation.

It's admirable to want to provide housing for a family member, HOWEVER they will make the cashflow of the property even worse. I assume you'll give them discounted rent or not raise their rents in the future. What happens when they start missing rent payments and you don't want to evict? You're cashflow drops to negative $5.3k...

This seems like it has bust written all over it. Move on to the next one.

Arlen Chou · Answer

@Vincent Roache I am guessing that this is an add on to your previous post about your mother's potential investing strategies. At a $3k loss per month, you would be better off just handing a check over to the family member on a monthly basis. There are a TON of unseen issues that come along with being a landlord that can suck up cash very quickly: repairs, potential lawsuits, etc.

The only way to make buy/hold work in the Bay Area is to find value add properties and figure out how to turn the under market tenants so you can renovate and get to market rents. In the "rent control" haven of the Bay Area, those are not simple tasks. Assuming this is related to your mother, what happens to her if they extend the covid emergency eviction moratorium? How many months can she carry a 1 or all units without rents coming in? Some people are made to "lawyer up" and make things happen, but first time landlords rarely are ready for the battle.

Be extremely careful with retirement funds. When people are young there are decades to make up losses, but after a certain point there literally is not enough time to make it back up.

Do not mix business with philanthropy, most especially when it involves family. Real estate is a business, treat it as such. You should never be ok with taking a loss. If the goal is to help family, then be clear that you are forgoing profitability and any semblance of best business practices and that you will bleed money.

I don't mean to be harsh or condescending. I have just seen too many people go down this road and end up creating deeper problems within the family and killing their dreams.

Good luck!

-Arlen

@Vincent Roache I am guessing that this is an add on to your previous post about your mother's potential investing strategies. At a $3k loss per month, you would be better off just handing a check over to the family member on a monthly basis. There are a TON of unseen issues that come along with being a landlord that can suck up cash very quickly: repairs, potential lawsuits, etc.

The only way to make buy/hold work in the Bay Area is to find value add properties and figure out how to turn the under market tenants so you can renovate and get to market rents. In the "rent control" haven of the Bay Area, those are not simple tasks. Assuming this is related to your mother, what happens to her if they extend the covid emergency eviction moratorium? How many months can she carry a 1 or all units without rents coming in? Some people are made to "lawyer up" and make things happen, but first time landlords rarely are ready for the battle.

Be extremely careful with retirement funds. When people are young there are decades to make up losses, but after a certain point there literally is not enough time to make it back up.

Do not mix business with philanthropy, most especially when it involves family. Real estate is a business, treat it as such. You should never be ok with taking a loss. If the goal is to help family, then be clear that you are forgoing profitability and any semblance of best business practices and that you will bleed money.

I don't mean to be harsh or condescending. I have just seen too many people go down this road and end up creating deeper problems within the family and killing their dreams.

Good luck!

Brian Garlington · Answer

You're a private lender and conventionla mortgage person, but you are using cap rate and 4 unit complex in the same sentence?

Can a 3.8% Cap rate (before financing) work?

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