All Forum Posts by: Brady Mullen

 Thank you, Justin!  The annualized rates of return I quoted do include debt paydown (although I didn't mention it specifically).  As you mentioned, debt paydown is a major oversight in most napkin-math calculations.  It makes a HUGE difference in return!

There's even a case to be made that in a negative cash flow situation, if you're paying down more debt than your monthly cash flow is negative, then you're actually buying equity at a discount.  People still need to be careful with cash flow, of course, so all I'm saying is "there's a case to be made."

Great point on the cap rate, too.  Chasing cap rate can be dangerous - it can lead to really challenging properties.  In most cases, there's a reason for a high cap.  That income doesn't come for free.

Cheers!

 I could not agree more.  That's kind of my point with all this.  People consider dipping their toe into real estate investing, see "cap rate" and equate it to a return, which it is not, of course, and think "5% isn't worth it.  I'd rather invest where my financial planner recommends."

Our challenge in the industry is to account for all the material things but present it in a simple and direct way to show them that a 5% cap property will probably perform better than your stock portfolio with even a modest amount of leverage.

Here's the amount you're investing, here's what you have in 1 yr, 5 yrs, etc. to show for it.  Here's how that compares to other investment options at your disposal.  It's up to you.

Thanks, James.  Your feedback is always valued.

Cheers!

@Greg Scott

Help me understand why cap rate is irrelevant for 1-4 units. From what I can tell, it is just used differently.

In multifamily or commercial, it is used to determine value, right? If it produces $50k NOI in a 5% cap market, the value is $1M.

In 1-4 units, it tells the buyer roughly how much NOI to expect for the price they're paying and helps compare to other options.

I will certainly say it is misused almost always, hence my original post here, but I can’t get to “irrelevant” in my head.

It’s a legitimate question. I admittedly don’t claim to be a multifamily or commercial expert, and I’m open to learning more.

Cheers!

Gotcha. My post was geared toward newer investors who are looking at SFR's or 2-4 plexes. They get hung up on cap rates, and they usually don't even know what it means. And the internet often doesn't help. Investopedia is a great sight, but it even defines cap rate as an investment return.

That said, the rates I used in my calculations are fixed, which doesn't really apply to commercial investing.  Sorry if I didn't make that clear in my original post.  Thanks, @Lucia Rushton!

 Can you expound?  I'm not clear on this.

@Julien Jeannot, I completely agree that early investors get hung up on cap rates and that a more comprehensive analysis over time is so much more helpful.  Thanks!

@Greg Scott, great point!  It's kind of this funny thing with some investors.  They seem to cling to cap rate irrationally.  It's one of those things I feel like I have to acknowledge because their perceptions are their reality (like the rest of us, I suppose).  Thanks!

Cap rate is a common and important measurement in real estate investing, but it seems I see it misused more often than not.

Cap rate is an income measurement only. It is a measurement of the annual net operating income (NOI) produced by an asset, relative to that asset's value. Annual NOI/Asset Value. That might sound simple, but it's so often confused with return.

NOI is the revenue minus operating expenses. These expenses include taxes, insurance, HOA, and even maintenance expenses (often missing in cap rate calculations on listings, by the way, so verify!) It is also key to note that debt service (mortgage payment) is not an operating expense, and there's good reason for that.

So, if a duplex receives $60,000/yr in rent, has $10,000 in operating expenses, or $50,000 in NOI (revenue minus operating expenses), and it is worth $1M, then it has a cap rate of 5.0%.

This is true whether you purchased it with cash or with a 75% loan from the bank because debt payments are not an operating expense. They are an acquisition expense.

If you're buying an asset with a 5.0% cap rate, that is not your return. Your return would be the cap rate plus any appreciation.  But not quite...

Your revenue (rents) and your expenses are also likely going to rise over time, so this has to be taken into consideration.

Lastly, this all goes nuts when you introduce a loan/leverage. You didn't exactly buy that property for $1M. You paid $250k, but now, much (or all) of your new investment's NOI must go to cover the mortgage payment.

This is usually when we talk about positive and negative cash flow. We want all the NOI to cover even the debt payment (both principal and interest), which it often does. This is downright remarkable, by the way.

This is harder to do when interest rates are higher, but it can be done by putting more down or investing in higher income markets, or getting creative in other ways.

When people confuse cap rate with return, they say to themselves, "Why would I invest in real estate to get a 5% return when I could invest in something much safer and with much less involvement and get 5%?"

That's a great question! You wouldn't.

However, cap rate is not your return. If you find a property with a 5% cap rate, and you assume 4% appreciation on the asset (averaged over time), and you borrow 75% of the purchase price at an 8% rate (I'm using that to show it can still make sense), your compounding annualized rate of return is closer to 11% over the next 5 years.

And if it appreciates at an average of 5% over the next 5 years, your annualized return jumps to 14% (the loan causes this anomaly where additional appreciation of just 1% will have that effect, which is why it is aptly called leverage).

What's even more outrageous is that your tax-equivalent rate of return is going to be another few percentages higher (depending on your circumstances) because real estate is generally a very tax-friendly investment.

Of course, you won't hear this from most financial advisors.