How important is the cap rate when making a decision to invest in multi family properties? is there is general rule of thumb for cap rates to be pofitable?
One thing you might want to look at is the relationship between the cap rate and the cost of borrowed capital (i.e. your interest rate):
A general formula to figure out what your True Cash-On-Cash Return will be...
Cash-On-CashReturn = Cap Rate + Leverage Ratio * (Cap Rate - Cost of borrowed capital)
(a) Leverage Ratio = Ratio of borrowed dollars to your dollars. For example a 75% LTV would be 3borrowed / 1own = leverage ratio of 3. Or on a $10M project, if you put in $3M and borrowed $7M...your leverage ratio = 7/3 = 2.33
(b) Cost of borrowed capital = Annual morgtge. pmt. / Amount borrowed. For an interest only loan this equals the interest rate, but for an ammrtzd. loan it will be slightly higher since some of your payment is towards principal.
If you run some numbers you will find that an ideal situation would be a high cap rate and a low interest rate. That way the borrowed money from the bank would be earning you more money...essentially arbitrage. If your cap rate is very low, around 4%, and your interest rate is around 6%. Your cash on cash return will be very, very low...much lower than 4%...maybe 1-2% depending on how much you borrow.
To show you an example...if you were looking at the following property: CapRate =.05, Int. Rate= .06 (interest only), Leverage Ratio = 3 (75%LTV):
CashOnCash Return = .05 + 3*(.05-.06) = .05 + 3*(-0.01) = 0.05 - 0.03 = 0.02 = 2%!!
Your cash on cash return is only 2% since your borrowed money costs you 6% and only makes you 5%.
*Just something to think about with properties that have LOW cap rates. This does not take into account appreciation/value you add by rehabbing the property* [ Edited by ckoenig on Date 04/04/2006 ]
Thanks for all your replies. I decided to pass on the property mentioned above (simply not enough free time to convert the lofts to livable space and to deal with the city...could have been something though).
Writing a contract on two duplexes that cash flow much better in the same area as we speak. Hold your fingers crossed for me!
Thank You very much!
Very Welcome!
http://www.thecreativeinvestor.com/commercial/modules.php?op=modload&name=Forum&file=viewtopic&topic=50348&forum=31
One thing you might want to look at is the relationship between the cap rate and the cost of borrowed capital (i.e. your interest rate):
A general formula to figure out what your True Cash-On-Cash Return will be...
Cash-On-CashReturn = Cap Rate + Leverage Ratio * (Cap Rate - Cost of borrowed capital)
(a) Leverage Ratio = Ratio of borrowed dollars to your dollars. For example a 75% LTV would be 3borrowed / 1own = leverage ratio of 3. Or on a $10M project, if you put in $3M and borrowed $7M...your leverage ratio = 7/3 = 2.33
(b) Cost of borrowed capital = Annual morgtge. pmt. / Amount borrowed. For an interest only loan this equals the interest rate, but for an ammrtzd. loan it will be slightly higher since some of your payment is towards principal.
If you run some numbers you will find that an ideal situation would be a high cap rate and a low interest rate. That way the borrowed money from the bank would be earning you more money...essentially arbitrage. If your cap rate is very low, around 4%, and your interest rate is around 6%. Your cash on cash return will be very, very low...much lower than 4%...maybe 1-2% depending on how much you borrow.
To show you an example...if you were looking at the following property: CapRate =.05, Int. Rate= .06 (interest only), Leverage Ratio = 3 (75%LTV):
CashOnCash Return = .05 + 3*(.05-.06) = .05 + 3*(-0.01) = 0.05 - 0.03 = 0.02 = 2%!!
Your cash on cash return is only 2% since your borrowed money costs you 6% and only makes you 5%.
*Just something to think about with properties that have LOW cap rates. This does not take into account appreciation/value you add by rehabbing the property* [ Edited by ckoenig on Date 04/04/2006 ]
Thanks for all your replies. I decided to pass on the property mentioned above (simply not enough free time to convert the lofts to livable space and to deal with the city...could have been something though).
Writing a contract on two duplexes that cash flow much better in the same area as we speak. Hold your fingers crossed for me!