CAP Rates vs. Cash On Cash Returns

by Annette Cooper

There appears to be a lot of speculation everywhere today about what is going to happen to cap rates and interest rates in the near future. A flat economy, burgeoning deficits, the costs of the Iraq war, election uncertainty, oil prices, energy costs, health care chaos, “baby boomers” tapping into an already stressed Social Security system and Alan Greenspan’s hints of interest hikes have taken their toll on the investment community’s perspective.

A capitalization rate is the percentage of return from an investment when you divide the Net Operating Income (NOI) by the price you are paying for the property (e.g. you buy an investment for $1,000,000 and the NOI is $100,000 annually – the cap rate on this investment is 10%).

Cap rates do not consider the costs of financing into the investment equation. Instead of buying into cap rate mania, a more important question to ask is: “What will be the actual “cash on cash” return on your investment dollar?” Before I launch into this, let me warn you that there are two things not factored into today’s equations. One is the obvious tax advantages of commercial investments such as depreciation, loan fees, interest, and other related tax benefits. These write-offs are very important, and extremely valuable. There are times when specific tax strategies may be the only reason to purchase investment real estate, but that’s not what I want to discuss here. The other really important topic I’m not going to discuss is real estate appreciation. This is extremely important in the overall return evaluation, but impossible to calculate at this stage.

Let me explain what I mean by “cash on cash return.”

First example: You have $500,000 in cash. What are some of your commercial investment options? Let’s use a maximum leverage strategy for this example. This concept is usually best suited to the multiresidential sector. Lenders have a soft spot for residential properties. Consequently, the loans available for apartments and multifamily properties have lower interest rates, and allow for a minimum down payment. Let’s assume your broker finds what appears to be a great investment for 2,500,000 with a 7.5% cap rate. Your income on this investment is estimated to be $189,600 annually.

A loan of $2,000,000 at 6.5% (amortized over thirty (30) years, due in ten (10) years), would cost about $151,000 annually. You would net approximately $38,600 per year. Your cash on cash return on this investment would be in the 7%+ range ($38,600 divided by $500,000: 7 .72%) with a very attractive leverage position. The principle on the loan amount is also reducing every year and building more equity. The reason this investment makes so much sense is that the income is greater than the financing costs.

Here is another example: Using the same $500,000, your broker finds you a beautiful Class A building. The purchase price is the same $2,500,000, but the cap rate is 5.5%, and the lower available financing is 6.5% for this property type. The 5.5% income is estimated at $137,500, but the annual loan payments are still going to be in the $151,000 range. Your cash on cash return is -$13,500 annually. You are still paying down the loan and building equity, but there simply is no cash on cash return on this investment. The spread between the financing costs and the NOI is a negative.

There may be good reasons to buy a 5.5% cap rate investment, but if the underlying financing isn’t in line with the annual income, you may want to think twice about what you expect from your overall return. When I started in this business, cap rates were a lot higher than they are now. The overall returns were probably about the same, because cap rates seemed to move up to accommodate higher interest rates. If interest rates move up again, I would anticipate that same phenomenon to hold true.

In any event, the typical anemic investment cap rates offered in most of the major California metropolitan areas are driving investors and 1031 Exchange buyers to search the Central Valley, as well as other states around the country that can produce more attractive returns.

The ability to communicate information through the internet has facilitated this exodus and I think the phenomenon are here to stay. Through this fairly new “lightning fast” communication medium, buyers now have instant access to investments that may yield a 7-8% cap rate and have an underlying financing potential of 6-7%. This creates an attractive yield, as well as tax benefits and appreciation potential.

Copyright: Annette Cooper

Annette Cooper, Top Ten Keegan & Coppin Commercial Real Estate Agents List, is based in Santa Rosa, CA specializes in 1031 Exchanges.