Could single digit CAPs ever work???

Question

I'm a newbee, first time post, but I've read more threads/articles/books about this subject than you can shake a stick at. I'm almost ready to put my plans and knowledge in motion...

I have been researching medium-sized multifamily properties (20-50+ units). I have an interest in acquisitions and holding for cash-flow. I believe â€œcash is kingâ€. I have found some great properties in fantastic locations, with decades of low vacancyâ€¦ even waiting lists for leasing!!! Some properties are university-associated student housing and some are not.

Even with inflated Gross Incomes and artificially reduced Operating Expenses derived from â€œLa-La landâ€ Pro Formas, these property still boast single digit CAP ratesâ€¦ as if they are proud to offer a property at 7%. I understand a lower offering CAP directly increases the property offering price. BUT by crunching the numbers, such a low CAP would never allow a 1.2-ish Debt Coverage Service Ratio required by most lenders. ESPECIALLY with an 80-90% LTV loan at current investment property interest rates and terms.

After leveraging a couple $M on a nice A- or B+ apartment complex, I would expect to have a sufficient monthly cash-flowâ€¦ perhaps to live/retire on, but that doesnâ€™t seem to be the case. The cash-on-cash returns are just not there.
Is there something Iâ€™m missing? Upon negotiations, does the seller realize how silly their asking price is and slash it by 30-40%? â€œHa ha, potential buyerâ€¦ you got me! I was just kidding about the ridiculously high asking price! Nice catch, I was just testing you.â€ Seriously? (AND do sellers actually believe I am going to consider vending machines and â€œclaimed depositsâ€ as property income???)

Or are lending institutions offering residential-style rates and terms for investment properties? (4.5% FRM for 30 years would be acceptable for me!) From what Iâ€™ve seen, investment loans are significantly higher with quicker pay-off terms.

The only way to make money on these low CAP investment properties are to hold and sell for increased value, or pay down the principle and pull out the equity at a later time. Sure it may be a strategy for some, but Iâ€™m not leaning towards that method.

It seems the only cash-flow values are found in smaller, blue-collar apartment complexes in â€œhome-town USAâ€ with proven track records of 10%+ CAP. True? Only then can an investor realize sufficient cash-on-cash returns.

Thank you for any feedback.

Account Closed · Answer

Sure, you can make money at a 7 cap rate, if it is a real honest cap rate with all real expenses figured in (don't expect that from a real estate agent). After all, it beats .05% interest rate on a savings account. Very few people just come in out of the blue and buy a multi-million dollar building. People investing at that level are doing a 1031 or have a big chunk of cash that needs a home. After all, the bank probably wants 30% down on a great big commercial loan. The guy who has only done a couple of flips is going to have trouble getting his hands on that much cash for the down payment. If you've got equity, the mortgage payments are smaller, and more of the income is disposable. And you know, you don't have to pay the asking price. You can always attempt to negotiate a better price. Asking price is the starting point, not the final deal. A lot depends upon where the property is located. A 10 million dollar apartment offered at 7 cap, negotiated to a genuine 8 cap inside the city limits of San Francisco, would be a screaming deal. Grab it if you can get it. A multi-million dollar 10 cap, or a 12 cap inside the slums of Detroit is a pass for me. I wouldn't touch it. Rate of return is a big consideration, but it is not the only consideration.

Bryan Hancock · Answer

Single digit cap rates work all all over the country in many cases. Many institutional lenders buy nothing but single digit product using an ultra low cost of funds. There are several threads about this on BP already so I won't rehash everything here. Here is a synopsis: LTV * loan constant < Cap Rate => Positive cash flow LTV * loan constant > Cap Rate => Negative cash flow Cap Rate is ROUGHLY (!!!) equal to gross rents divided by 2. You can look through the tens of posts where we bickered about this too and where it does and does not apply. Note that you can negative cash flow for YEARS on a project while making improvements to the operations, appearance, etc. and still have a positive IRR project by making a bundle on the reversion cash flow when you sell. This "betting on appreciation" is often scoffed at on BP, but it is a valid business model for many well-capitalized investors bidding on stabilized product. As Vikram pointed out the analysis gets MUCH more complicated when you introduce time value of money principles as it does with ANY investment analysis. Neils Bohr once said, "Prediction is difficult, especially about the future." Unless your crystal ball is calibrated precisely or is a newer model than mine rent escalators, inflation rates, zoning changes, etc. are all GUESSES and thus a more complicated analysis is dubious at best. Commercial debt has a higher constant than residential debt in many cases because of how it is traded and guaranteed. Many commercial loans are portfolio product and have shorter amortizations, which drives up the loan constant appreciably even with coupon rates close to what they are for resi debt. Whether or not something "makes sense" depends on what you are looking for. Single digit product generally carries lower risk than double digit product, which requires a lower cost of capital for the buyer to make it make sense. If your required return to equity shareholders is high it may not make sense. It all depends on your business model.

Vikram C. · Answer

Your return is not the CAP rate. That's your first year's unlevered cash yield. Your unlevered return is a function of the CAP rate and the growth in rents (and potential exit time and price if you choose to capitalize the rent growth). CAP rates will be lower in a market where people expect rent growth and higher in a market where people do not expect it. The trick is to identify markets where people do not expect rent growth but you have good reason to believe that growth is likely to occur. As in other types of investments, this is akin to looking for a needle in a haystack.

Jon Holdman · Answer

When I see "proforma" I read "pre-tend" and ignore everything in that column. Even actuals tend to be distorted in the info from sellers and their agents. Read in the rental property forum about the 50% rule, and assume that as a best case. That is, NOI is, at best, 50% of gross scheduled income. At worst, it can be much worse. Commercial properties make money if the cap rate is higher than your cost of capital. If you have a 7% cap building, and can borrow money at 6%, you make the spread. You make the full 7% on your down payment and the difference, 1% in this example, on the financed amount. That amount is typically called "total return" in property listings. That's because you probably have a principal payment, too. That reduces your cash flow to a lower value than the total return. A better way to estimate this is the "money factor" which is the annual payment divided by financed amount. That will always be a little higher than the interest rate, a lot higher for short amortization periods. I think there is zero chance of getting a 90% LTV apartment loan these days. Getting a 4.5% 30 year loan on an investment property of any type is a pipe dream. Those are owner occupied terms, not investor terms. You can make money on a property like this by just paying cash. Your return is the cap rate. Plus depreciation lets you shelter much of the income, making the effective after tax return higher. Though you will pay back deprecation's benefits when you sell. 7% isn't that attractive, IMHO, but compared to 2.5% for bank CDs its acceptable to some folks. Alternatively, a property like this may be a long term play. If you can be break even while its being payed down, you can get the full cap rate once its paid off.