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.

[David Hanson]

Eliot M. I like it. What you're detailing out is cash-on-cash return (cash flow / out of pocket) and that is another practical measure of the value of the deal. Very helpful, thanks!

[Jesse Fragale]

@David Hanson i often hear people looking at the spread between the mortgage rate and cap rate (for instance in Toronto a 5 year fixed may be 2.7% and a cap rate could be 4.8%) and immediately thinking its a cashflow deal if the number is positive. This is misleading and would only apply to interest only loans...as a result the rates cannot be looked at as if they were an interest only loan. In terms of DSCR, 1.00 is typically not acceptable to traditional lending institutions. In Canada, many lenders need >1.25. I would contact the underwriter/mortgage broker.

Lastly, I would recommend that you add a management figure (typically 4% of NOI for apartments), and a R&M (repair and maintenance) figure when calculating NOI...and by extension a 'cap rate'. Many investors overlook these items and find out the hard way once the building is professionally underwritten and the lender tells you what the real cap is. They may even include capex reserve ($250 per unit up here)...but I know it is a contentious topic--whether capex reserve is below or above the NOI line.

[David Hanson]

Jesse Fragale Good clarification and I was really just asking whether there was any relationship between interest rate and CAP rate and seems there is however low of a correlation it might be, i.e. In a higher interest rate environment you typically need a higher cap.

Currently in the analysis I've got a mgmt fee of 8% of gross rents built into the expenses so I guess above the NOI Line. Interesting comment that the mgmt fee should be based on NOI rather than gross rent. I think around here most mgmt companies take a percentage of gross rents but I'll need to check.

As mentioned I've got capex reserves at $500 per unit per year also included/above NOI line and another $6k for repairs and maintenance which is a number the seller gave me so I'll need to dig into that too. Thanks!

[Jesse Fragale]

@David Hanson my apologies! that should be a percentage of gross rent...you're correct.  Here's an interesting take on capex reserve...some will argue that it is not an operational expense and should not be capitalized (the article takes the opposite view): https://www.google.ca/url?sa=t&rct=j&q=&esrc=s&sou...

One interesting relationship...not exactly 'interest rates' but related is that there is certainly a correlation between cap rates and the 10 year treasury note (I work in commercial real estate as a broker and its a spread we always keep an eye on).  The spread is at historic highs in many areas in the US and Canada.  When you see that spread increase, you could make the argument that there is more room for cap rate suppression...or higher values for real estate.  The spread itself is the 'risk premium' paid to investors to choose real estate over the 'risk-free' return of the treasury (or 10 year GoC Bond in Canada).

[David Thompson]

David,

For mgt expenses, you want to base that off the Gross Effective Income (not NOI) to use as the % of management fee. Gross Potential Income + Other income less all the top line deductions such as Loss to Lease, vacancy, bad debt, etc.

http://smallbusiness.chron.com/calculate-effective...

Yes, cap rates have at least 3 things that impact it which is demand for apartments, the more demand the lower the cap rates as prices get bid up; interest rates, growing interest rates will increase the cap rate and credit availability...amongst other inputs. It's a bit complex. To be conservative, always underwrite w/an expected increase in cap rate at exit as this negatively influences the fair market value of the asset. NOI/cap rate = FMV. See components of a cap rate link below.

http://www.propertymetrics.com/blog/2013/06/03/cap...

[David Hanson]

Jesse Fragale thanks for the article, I'll read.

Wrt the 10 year treasury that makes sense as a comparison based on risk, I get that.

[David Hanson]

David Thompson Looking at my numbers I did base the mgt fee as a percentage of gross effective income and used 5% as the vacancy rate (seller provided) with no other deductions.

I'll check out the calculator and definition article. Thank you.

[Troy Southerland]

@David Hanson

This is also one of those things that really depends on how you feel and what you need. You definitely want to be profiting every month. Investors have their own opinions. For cap rate, I try to aim for 10% but try not to get less than 8%. For cash flow, it definitely has to be positive - some people get a 20% return.

[Stephen Franco]

I do it as

gross rent - 10% mgmt - 10% maint - 10% vacancy - landlord hard costs =noi. minus $75/door for profit, and balance at 6% for 20 years.

if it doesnt cap rate over 15% cap rate or 21% cash on cash I move on.

[David Hanson]

Stephen Franco Interesting, where does the $75 per door profit come from?

[Tricia O'Brien]

Hello David Hanson,  I was wondering how an equity partner works... you mentioned in your post yesterday you might want an equity partner to help with the down payment.  Would that be someone who, for example, puts up $100K for the down payment and then gets that money back in 5-10 years (plus interest) when you sell? Or does an equity partner get a % of the annual cash flow, if any? Or both ?

[Account Closed]

I would say you need at least a 2 point spread on the cost of capital and the cap rate.  If your cost of capital is6 then you need an 8 cap. You can't make a 5 cap deal work with a 6% mortgage rate.  Also make sure you believe the expenses on the cap rate.  A lot of sellers tweak the numbers via a proforma to make the cap look better. 

[David Hanson]

Tricia O'Brien to date I've only done a 50/50 partnership where everything is split, but I've heard it done both ways you mention, including one where the equity partner gets interest on her loan and a split second of the appreciation and the principle investor gets the cash flow (in fact I think Brandon Turner said he did that).

Someone else may know If there's a common way equity investments are structured.

[David Hanson]

Brian Doyle the seller has told me the current rent and what it could/should be (proforma) and I plan to check all the leases as thoroughly as possible to confirm.

The other advantage to this deal (hopefully, if the above is true) is the forced appreciation I'll get by raising rents to market rates.

[Antonio Guerrera, Jr.]

Hi David,

Forget about what the seller would accept, cap rate, and 2% rule. Cash flow is king in this discussion. If you have no cash flow then you are banking on appreciation and deductions and that can be dangerous in this frothy market. Actually, this is why cap rate is so low, because price is so high in this market. Bottom line is if you don't cash flow for all the risk, it is absolutely the right call to move on to assess the next property.

Good luck and keep us informed,
Anthony

[Eric Li]

Hi @David Hanson, by looking at the numbers, a 5.8% Cap rate is a reasonable return. However, if you have to get a mortgage (debt service) and the return become zero, then I wouldn't think its a good idea to invest.  If something goes wrong such as tenant not paying, repairs on the house, etc.  You investment will go negative.  Also, I would consider comparing this with Dividend stocks.  If a utilities stock can give out about 4% return, I might just go with dividend stocks (no headache and easily liquid).  So my recommendation is finding something that can gives you more than 6% return in both with or without debt service.

[David Hanson]

Antonio Guerrera, Jr. My goal for the next few properties is focused on cash flow so I won't do the deal unless I have significant cash flow. Thanks for the support.

Eric Li Those comparisons to safer returns are helpful.

I meeting with a commercial broker at a local portfolio lender today and he will review the numbers and tell me what their requirements are. That will help a lot to understand the strength of the deal at least in context of what they'll lend on, I already know their DSCR minimum is 1.2.

[Account Closed]

Hey David, 

You might ask for a copy of the sellers K1 and or schedule E for this property. I think it is super important to base any ROI calculations on actual numbers not projections. If you can't get them then I would almost suggest you need to be extra careful on your budget projections. You would also want to reserve for larger expenses called capital improvements. This deal sounds a little lean to me.

[Adam Franco]

Who is to say those are max rents? What happens to the cap rate when you raise the rents?

[David Hanson]

Brian Doyle Agreed, Definitely will look at all financials if /once we get to MA.

[David Hanson]

Long post but wanted to get you all caught up.

Getting up the courage to make an offer.  Here are some of the changes I've made to my numbers in the past 10 days partially based on this thread and a lot of reading:

1. Property tax: increased by 20% to account for the county possibly increasing that based on the sale

2. Capex budget: Broke down individual large ticket items such as roofs, water heater, appliances, asphalt repairs, flooring, heaters, etc. by the effective and remaining life to create a capex budget. The buildings are old so that number turned out to be quite large (almost $1400 per month) and really affects cash flow and cap so not sure that's the best way to think about it. I then figured I'd give some credit to the probability of increasing rents to sort of offset that, thinking that its not quite fair to budget for future capex spend without also assuming some rent increase in that same future time period (some of the units already have had their rents increased so I believe such rent increases are plausible). Any thoughts on that?

3. Compared property mgmt companies and came up with 8% average 

4. Quoted insurance and it's more than 3x what the seller tells me he pays so not sure what's going on there and I need to double check the quote.

5. Down payment: little less than 10%

6. Total cash: budgeted for closing costs, inspection and initial repairs needed.

OK, At my projected offer price (which is $250k below asking) I'm happy with all the numbers:

CAP: 7.4%

Cash Flow: $850 per month

CoC return: 16%

DSCR: 1.23

I think I've covered off most everything but if you guys see anything odd let me know.

The biggest issue IMHO is the offer price being so much below the asking. I'm going to write up an LOI but not sure when I'll have the guts to send it to the owner.

Cheers.

[Stephen Franco]

sorry, i just saw your note about my $75 per door profit. here's how it works

rent

-30% for maint, vacancy, management

-hard costs

______

NOI

- 75/door/month profit

this determines max mortgage payment.

Normally pays for 25-30k/unit