Comparing interest rate with CAP rate

[Pinaki M.]

Hello, maybe someone can make this more clear for me. I used to think that as long as the interest rate of an mortgage is less than the cap rate of the investment, the investor is guaranteed to make positive cash flow every month and end up with a cash-on-cash return which is greater than the cap rate. However, working through the numbers for a few potential deals, this does not appear to be true. 

For example, I was looking at the property for which the price is $1,100,000. According to my estimates, this would result in a gross profit (cash flow before mortgage payment) of about $65,000 per year, which is just over $5,400 per month. So the cap rate is 5.9%. Now, taking a loan with 5% interest rate, 15 year amortization and 20% down, the monthly payment comes to about $6,950.

In the above example, since the cap rate is greater than the interest rate, my thinking was that I will make some positive cash flow in the end, and that the cash-on-cash (with 20% down in this case) will be higher than the cap rate (which is basically 100% down). But of course, this is not correct, as the numbers above prove.

My question is, is my understanding completely off the line, or am I missing something small? Is there any relationship between the cap rate and the interest rate at all which will quickly tell me if the investment is cash flow positive? I mean something intuitive, without having to do the whole calculation.

Thanks.

[Immanuel Sibero]

@Pinaki M.

Cap rate is designed to be a valuation metric which has little to do with interest rate. However many investors insist on using cap rate as a performance metric (i.e. measure of income/return). As a performance metric, there certainly is a relationship between cap rate and interest rate since interest rate does affect performance of the investment.

Using cap rate as a performance metric, I think your understanding of the dynamics between cap rate, interest rate (i.e. cost of capital) and cash-on-cash is generally correct. As a matter of fact, you have just described the principles of leverage. What is not always true, however, is your statement - "as long as the interest rate of an mortgage is less than the cap rate of the investment, the investor is guaranteed to make positive cash flow..."

From the formula, we know that cap rate starts with NOI (i.e. revenues minus all operating expenses). To get to cash flow you would normally pay out loan interest, loan repayment, and capital expenditures. This notion of "guaranteed" positive cash flow is only good when you pay out loan interest only (i.e. cost of capital) beyond NOI. In this case, YES you will always cash flow because you take in 5.9% and you pay out 5.0%. As soon as you make additional payments beyond loan interest (i.e. loan repayment, capital expenditures) then there is no guarantee you will have positive cashflow.

So the quick rules of thumb for guaranteed positive cash flow are:

• cap rate is greater than interest rate (you've got this)
• the difference between cap rate and interest rate should be large enough to produce cashflow to cover loan repayment/amortization and capital expenditure plus some amount left over for the investor.
• if you're in a deal where you're financing with interest-only loan payment and there is no capital expenditures, then YES cap rate being higher than interest rate would very likely produce positive cash flow.

Cheers... Immanuel