All Forum Posts by: Brady Mullen

I recently posted "Cap Rate Is Not Your Return" and had some really interesting conversations from it.  One I wanted to bring up as a separate post is how cap rate is used in commercial real estate investing verses residential (1-4 residential units per property).

I had many commercial investors say that cap rate is irrelevant in residential investing, and I want to suggest a different approach.

Before we go further, if you're unfamiliar with cap rate, the formula is Cap Rate = Net Operating Expenses / Property Value  OR  Net Operating Expenses / Cap Rate = Property Value.

First of all, cap rate in commercial investing is a variable that describes a market.  For example, class B commercial buildings in a certain part of Wichita, KS may have a 6.5% cap rate (I have no idea if this is true), which means you can find the annual Net Operating Income (revenue minus operating expenses), divide by 6.5% and come up with the value of the building.

Cap rate, in this context, is used to determine the value of a commercial building.

I am not a very experienced commercial investor, so if you are, and you are reading this, please correct me if I'm missing something.

Conversely, residential values are not based on cap rate.  They are based on comparable properties that have recently sold.  However, this does not mean that cap rate isn't helpful for residential investors.

Cap rate in this context can help an investor compare two different properties that have different profiles and determine which one pays more income relative to the value of the property.

Let's compare two properties to illustrate what I mean:

1) This property is available for $329,000, rents for $2,100/mo, has annual taxes of $1,300, annual insurance of $984, an HOA of $35/mo, and is in decent shape, but you want to assume it will take roughly $2,500/yr in maintenance and capital expenses.

2) This property is available for $475,000, rents for $2,900/mo, has annual taxes of $1,630, annual insurance of $1,216, an HOA of $50/mo, and you're assuming roughly $3,100/yr in maintenance and capital expenses.

It's tough to compare these quickly without calculating a cap rate, which shows which one creates more income relative to the cost of the property.

Property 1 Analysis: NOI = $19,996 (annual rents - annual operating expenses). Therefore, the cap rate (NOI/Property Value) is $19,996/$329,000 = 6.08%.

Property 2 Analysis: NOI = $28,254. Therefore, the cap rate (NOI/Property Value) is $28,254/$475,000 = 5.95%.

This helps see that property 1 (cap rate of 6.08%) creates more income relative to its value than property 2 (cap rate of 5.95%).

This is just a quick comparison, so I'm glossing over things like projecting some vacancy and some other details, but I hope it gets the point across.

Again, this is different than how cap rate is used for commercial analysis, but it's not unhelpful.

Lastly, I'll mention that cap rate is not everything.  Property 2 might still be the better buy based on location or other factors.  Cap rate is just another metric that is helpful in underwriting an investment decision.

Happy investing!

Quote from @Sam Yin:

There have been some pretty bold claims on this thread. Nice to see the BP banter about investing, risk, cash flow, and REI headaches continue in perpetuity.

I would like to add that there are those that view REI as a hobby, a side hustle, trophy collections, while others look to it for financial freedom, wealth building, and as a lifestyle. Some on this thread appear to more of the former than the latter.

It is my opinion that those who are looking for financial freedom or to use REI to sustain a lifestyle will tend to use cash flow as a primary metric. The other metrics are a bonus, but cash flow will allow them to get off the W2 treadmill. As they grow, they generally tend to either create better efficiencies through management refinements, or some transition to syndication.

At the other end, those that either have great jobs and want to dabble, or already have a steady cash flow and want just to collect more or pursue a dream of generational wealth building will chant the mantra of cash flow is not everything. They will tout that it's about appreciation, long term hold, buy in A areas with negative cash flow but greater potential, etc...

The point is that there is no one size fits all strategy. However, there are best practices and efficient strategies for each individuals situation and goals.

I think we, as a collective forum, should be cognizant and preempt our ideas with the background and basis of the claims. This will help members, that come from various stages, to better understand what investment philosophy might help them best.

I, personally, am not in the position to buy knowing a negative cashflow for a year or two is the outcome. I feel the opportunity lost is too great in that time frame. I have made deals with a negative cash flow projection, using bridge debt, but only because there is an untapped $2M - $3M equity that just needs a few months of shuffling paper and adding lipstick. Even in those situations, the cash flow is closer to zero versus negative. Outside of those opportunities, it must cash flow because it is a business that must sustain itself.

I chose to make REI my only source of income to sustain my lifestyle, my family, and to build wealth. For me, I do not see any good that will crome from the original OP. But I understand that it is an option and a play for those that do not need the cash flow. Or for those that just want to collect grade A properties for the future, as trophies, or for their heirs.

I say this because I question if anyone who banks on appreciation ever does a stress test on their portfolio. Will they be able to sustain a 15% to 30% reduction in gross, and still be able to maintain the properties, especially if refinancing/sales is not an option due to a credit crunch? If their other source of income is great enough to withstand that, then I think the original OP philosophy is golden. If not, you better re think investing for cash flow.

My strategy is to maintain 65% or less LTV position. I strive to keep my margins above 30%. The model also involves not more than 4 to 8 hours of actual required work from my part. Thus, cash flow was key. When I add depreciation, appreciation, passive income tax benefits, 1031 rules, write offs, and other tax strategies, it works best for me right now, later, and after I die.

Just my 0.02

Great post!

I want to be clear that I never recommended negative cash flow. That is only acceptable in the case you mentioned where you have enough reliably disposable to be comfortable with that.

I was just pointing out that real estate generally is still a good business to buy. But if you need to break even or cash flow positively right out of the gate, and you’re not willing to put more than 20-25% down, then your options are more limited than they were before.

And the “before” I’m referring to is not coming back anytime soon, so we need to stop waiting around for it.

Thanks for chiming in, Sam!

IMO, using leverage is a matter of timing when you want the income from a portfolio.

For example, the more leverage you use, the more your returns will be (assuming you hold long enough to even out fluctuations) because appreciation on your leveraged property will usually provide more wealth than any other element in real estate investing.  If you put 10% down on a property, and it appreciates by 10% (let's say in 2 or 3 years), you've doubled your wealth.  You'll probably have to subtract from that gain some negative cash flow (10% down may make cash flow off the bat tough), and you can add some back in for tax benefits and debt reduction, but the wealth on your balance sheet grows fastest this way.

This is not to say 10% down and negative cash flow is good. I'm just saying that leverage and appreciation are the source of most wealth creation in real estate. So if you're aggressively trying to build wealth and you have a steady and healthy source of income in your life, keeping your LTV as high as you can afford without taking uncomfortable risks will build wealth faster.

Someday, however, you'll want to optimize for income.  In almost all cases, the best income scenario is a paid-off property.  Your overall returns will be less because the leverage is gone, but that will matter less when you're most interested in receiving monthly checks.

So often people get excited when they achieve some nice cash flow from a property they purchased a few years ago, and their instincts tell them to leave that alone.  Of course, if they need the income, that is exactly what they should do.

But if they don't need the income anytime soon, they should probably use that "stale equity", raise the LTV on that property with a refi or LOC, and go acquire more.

If they do this, they will give up that $1000/mo (more or less), but they'll have two properties, and the income when they do need it will be much higher than it would have been otherwise.

This is awesome, Salvador!  Best of luck to you!

Quote from @Henry Clark:

Who gave you the cap rate?

Let’s say it’s 7%.   I can make it 9% or 5% if I know you plan to sell coming up.  All legal.  All proper accounting.  
.   
The investor needs to validate every line item.  
.    

I totally agree. I always run my own NOI figures because I don’t trust cap rates from listing agents. Also, I work in the res space, where a large portion of professionals don’t really understand cap rate anyway.

Quote from @Chris Webb:

This is true, it is great for the comparison of commercial properties. I recently talked with a young person who asked if my real estate finance courses helped in my personal investing. I told her "Absolutely not!" These courses are for analysts who work at CBRE, not for general investors. If someone is new, generally, cash on cash return is the metric that should be used. Anything else has little effect on short to mid-term results. Also, some markets are much different and appreciation is the play. 

Thanks, Chris, for responding. I know that in commercial RE, cal rate is used often and for something specific. In res investing, I think it has a role, too. Different but useful to compare the NOI of your property as a percentage of the value.

Do you not find cap rate useful in res investing? If not, why not? If I’m comparing NOI between two properties that are different values, cap rate is a good way to compare the net income these two properties create. 

This is a legitimate question, as I have very little comm experience.

Cheers!

Quote from @Steve Vaughan:

I like the theory, but am with @Allan Smith as to it's difficulty, effort and indigestion.  

For the pain, we get control and the opportunity to purchase below market value and or creatively.

But there are tons of moving parts and people to deal with.  An entire huge industry is there specializing in it's acquisition and exit and they are not cheap.  

A purchase contract averages 26 pages.  My exit paperwork from an asset last year was over 50 pgs. Then there's the taxes to file, especially after sale / exit/ relinquishment.  Most need a tax professional for that as well. 

Stocks, funds, reits are a button and a clean 1099/98. RE is very complex. 

I’m on the same page with you. It’s not nearly as straightforward as other assets, and I tried to stress that, as well.

Thanks for reading and commenting!

Quote from @Allan Smith:

Now imagine that that stock is a bit of a pain to purchase and operate and that most people don't have the bandwidth to add it to their schedule.

I've come to this realization only recently. I've been blessed to get dozens of rental units and they have been very impactful financially, but I realize that most people can't hardly manage this while working their full-time job. Plus there are so many mistakes you can make along the way, whereas stock is just a couple clicks.

I would recommend real estate to pretty much everyone, but I know there are a lot of people who don't have time or want to deal with the headache of it. Even if they hire a property manager it's still very hard to find deals and you have to go get the loan , keep an eye on it to make sure the property manager is doing their job, Etc

I completely agree. Real estate investing is not passive and isn’t for everyone.Thanks for reading and responding!

Consider this for residential real estate investing:

Imagine there was a stock you could buy that pays a 5% dividend or so. (cap rate)

Imagine this business provided a product/service that literally everyone needs.

Imagine the product/service this business provides is on back order for a decade. (low inventory)

Imagine this stock was historically significantly more stable than the S&P 500 Index.

However, this stock typically appreciates meaningfully less than the S&P 500, but because of it's reliably predictable appreciation, the banks would lend you up to 80% of the value of this stock at a fixed interest rate slightly higher than inflation to purchase it.

Imagine if rates dropped, you could replace that loan with a new, lower interest one?

Imagine there were all sorts of tax benefits for doing this.

Due to the ability to leverage this asset, collect income, enjoy preferential tax treatment, and expect appreciation over time, historical returns on money invested are regularly and meaningfully higher than the S&P 500 with dividends reinvested.

How much would you buy?

Wouldn't it be a great if you could purchase this stock so that the 5% dividend covered the cost of the payment to the bank? What?!

What if it didn't quite? What would you do?

Would you borrow less? Like 70% instead of 80%, just so the dividend would cover your payment to the bank? Maybe. That's a good strategy.

Or would you borrow 80% still, and pay the difference each month for a few years? Maybe, if you were very confident in your ability to pay this. After all, you figure you're still getting the ownership of this stock for a fraction of the overall value.

Furthermore, you recognize that the 5% dividend on an increasing value is an increasing dollar figure, so eventually, the dividend will entirely cover the payment to the bank. And, eventually, you will receive the entire dividend with no payment to the bank because the loan is paid in full.

Or would you walk away and complain that you used to be able to purchase this stock with 20% down (an arbitrary number, by the way, based on PMI, not the bank's concern for your entitlement to positive cash flow) and the dividend would cover your entire payment and then some in the first year? Maybe… at least you're in the comfortable majority. It's not a good deal anymore, right? Better to wait, expect, and feel entitled to bank rates that are unrealistically low and not likely to return in our lifetimes.

What would you do?

This is not a perfect analogy. Here are a few caveats…

Real estate is not fungible, so it matters which real estate you buy. You can't be careless about it - you have to do your due diligence.

Real estate is also not passive. Anyone who says it is doesn't own any. You're a business owner when you buy rental properties. However, in exchange for more responsibility, you also get a lot more control over your investment than in a traditional stock, where your only control is to own it or not.

Real estate is a concentrated asset. With a small amount of money, you can have a diversified portfolio of stocks. Diversifying with real estate takes a lot more capital.

Lastly, I am not recommending negative cash flow. But it is true that if values rise, the more intelligent debt you use, the better overall return you'll achieve, even if your cash flow is negative. And if a few hundred (or thousand) dollars a month is no big deal to you, and your objective is aggressive returns, then negative cash flow in favor of higher leverage can make sense. That said, negative cash flow should be considered very cautiously. Liquidity is a metric every business and investor should regard as sacred.

I'd love feedback and insight on this idea! I am a retired financial planner (more like disenfranchised), and I deliver a lot of CE courses to RE agents and their clients in Colorado, and I'm always thinking of helpful ways to explain real estate and financial concepts. I woke up at 4:30 this morning with this idea in my head, and I had to write it down and get the BP community feedback - I love this platform! Thank you to anyone and everyone who shares ideas!

What would I do if I knew where rates would be in one year?

I'd like to make a simple argument. I'd buy either way. I know this sounds a little too simplistic, but I literally sold my financial practice after 18 years because I became convinced that real estate is where I needed to invest. So hear me out.

Rates Rising…

If I knew rates were going to rise, I'd buy now to get a rate lower than I would be getting gin the future. I'm a firm believer that values will not drop substantially while there is such an inventory shortage. Remember, we're talking about shelter. This is something people cannot do without.

For the record, I recognize that there are some markets across the country that I would not touch, but there is no shortage of healthy suburban areas where I'm comfortable investing in RE, and I would be shocked to see a substantial and widespread crash in values.

If that happens, I'll eat my words.

I believe if you purchase good assets in landlord-fair states/communities and for the long haul, appreciation is a reasonable thing to expect. If you disagree, please share two things: 1) Why you believe that, and 2) what do you recommend instead? And don't reply with "cash" or "sidelines". I don't consider a government's currency an "investment." It's the current between assets, not an asset by my definition.

Rates Falling…

If I knew rates would be lower, then I'd be willing to invest now with a confident expectation that when rates drop, the demand for my investment will rise as more people will re-enter the market.

And of course, I'd restructure my debt at a lower rate. I know this costs money, but do you know how much 5% appreciation on a $500,000 asset is? I think 5% is conservative if rates fall meaningfully, by the way. I'll take the appreciation and pay the cost of refinancing every time.

In short, the only reason I care about interest rates is because I need to enter the rate in my underwriting calculations. Of course, if the deal doesn't make sense, I won't buy it, and the rate does play a part in how well something will cash flow.

But rate alone should not keep anyone from purchasing a good asset with the bank's money.

Not to beat a dead horse too much, but remember the big picture here… The fact that you can borrow money at any reasonable rate relative to inflation to purchase a necessary asset that reliably appreciates over enough time and creates income is phenomenal.