How much cash flow and cap rate is enough?

[David Hanson]

Need some advice. I'm looking at a 12 unit property that IMHO is overpriced because it breaks even ($0 cash flow) after all expenses and debt service (1.0 DSCR). Cap rate is 5.8% which doesn't seem too bad. I'm trying to figure out an offer/purchase price so my question is, how much cash flow is enough? The lower the price the better the cash flow so at what price and cash flow should I be happy and decide to do the deal? For example, to get to a 10 cap I would need to pay $410k less than asking which I doubt the seller would go for. Maybe an 8 cap is enough for me which would be about $270k below asking. Should I look at my cost of money and add some margin there to get to an acceptable cap rate? Or are those two numbers not relatable that directly? Whatever the number is, how do I justify that price/offer to the seller? I don't think sellers care about the 2% rule. Aside: also having trouble figuring out if there's a going/common cap rate for similar properties in my area. Is talking with commercial brokers the best way to determine that? I could also look at sold properties and what their cap rates are but there aren't many that similar. Thanks for any advice.

[Jeff Kehl]

@David Hanson There are a lot of variables involved so it's hard to answer your question.

How much are you putting down? What interest rate over what term can you get on borrowed money? What return could you get on your money if you did something else with it? Are you expecting the property to appreciate or are you after just the cash flow? Are the tax deductions from the depreciation useful to you? How much risk is there of a recession in the next few years? If there is a recession what would your occupancy fall to? Can you find a manager to manage to the cap rate the current owner is getting?

You said:

"Should I look at my cost of money and add some margin there to get to an acceptable cap rate?" Yes for sure but also the opportunity cost of the money you put down. I'm a finance guy and this gets complicated for me when I think about it so let me give you an example where a lot of the variables are constant and the numbers are simple.

Let's assume your purchase price is $1 million, a 6 cap and you can borrow 100% of that at 5 % INTEREST ONLY. Should you do that? Well you have invested nothing and the property pays you $60k per year and your loan costs $50k per year. So you make $10k/year and have no money invested.

At first glance it seems you should do that all day long. Invest nothing and make $10k/year is an infinite return. Do a dozen like that and you can live the good life like the gurus predict.

But hold on, even in this simple example many of those variables could change on you. Let's start with the NOI number because I feel it is the most critical. There are many variables that make up the NOI but let's again simplify a bit.

Let's say you have 12 units that rent for $833.33/month or $10k/year. Total gross rent is $10k/unit per year or $120k total potential gross rent. You experience exactly a 50% expense rate resulting in the $60k NOI we discussed above.

So again we're good and you should do the deal all day long. But look at what happens if you change a few variables for the good or for the bad...

For the good (this is what you will mostly hear about) Raise the rents $100/month or lower the expenses $100/month. NOI is now higher by $100x12 units x 12 months= $14,400. At a 6 cap you just made your property worth $240k more which is an even better infinite return on $0.

But let's talk about the bad for a bit because you won't hear this from the gurus. Here's a few variables on the bad side.

A) 50% is performing well, If you don't have a good, honest  property manager you could easily lose 10-30%  or more while you find one that works

B) Even if you have a good property manager, In all likelihood the previous owner put in tenants that aren't great ahead of the sale. You'll need  to evict 10-30% of them to get a good solid tenant base.

C) You /Your inspector missed a something during due diligence like bad septic tanks/sewer pipes, old trees that need to come down, some legislation that causes you to replace safety equipment, a bad parking area with a spring under it, a leaky roof, a bad boiler.

D) A recession hits and your occupancy/rents drop.

E) Some utilities are being owner paid boosting expenses past 50%.

Again in the interest of keeping things simple let's say one of the above five things drives your NOI DOWN to $40k for the first two years so instead of making $10k each year for the first two years you lose $10k each year. If you have the reserves to cover this you're fine, if not there goes the property.

Keep in mind my financing assumptions are way better than what anyone really uses. You have to put money down or borrow from investors at what 12%?

Sorry for the length of this post but if you've read through it to this point hopefully it is helpful. It is helpful to me to write it out as I try to structure my own deals.