“How can a cap rate in the mid to low single digits sustain an investment in properties?” This was a recent question asked by a real estate investor when brokers in the area categorized current capitalization rates as normal. To answer the question a theoretical investment model must be formulated. The factors that play into this model are the investment amount, cap rate, lending rate and amount of leverage. Assuming the capitalization rate is 5%, the lending rate is 5%, and the property is 100% leveraged, this will provide a net cash flow of 0. Although this is a theoretical model it will provide the basis for our real-life example.
Historically, risky or weak investments have often been marketed as normal, thereby lulling investors into a false sense of security. The Madoff scandal and collapse of asset-backed securities are prime examples of opportunities that appeared to be secure. Though the past is full of such examples, history seems to keep repeating itself.
When providing advice and making investment decisions, knowledgeable brokers know that there are always risks and rely on proven statistics rather than personal opinions. Any broker who uses generalizations to describe the state of the market is either inexperienced or untrustworthy. Opinions should always be backed by the math of the transaction.
Capitalization rates in the range of 3.5% to 5% are less than the rate lenders currently charge for mortgages on income properties. One of the crucial investment rules that applies to income property is to never invest with a negative spread, a cash-on-cash return lower than the mortgage rate. Why is this rule so important? Every penny borrowed on an income property with a negative spread is a guaranteed loss. Simply stated, if the capitalization rate is 3.5% and the rate to borrow is 5%, every $100 borrowed results in a $1.50 annual loss. Given this example of a 1.5% spread at 70% leverage, cash flow is terminated.
Because the cash-on-cash ratio for a negative spread results in a low percentage, this type of property tends not to contribute to asset generation, which results in decreased property value. Using cash-on-cash return is a quick way to identify a negative spread. This percentage is simply the ratio of annual income (before taxes) to the total amount invested. Income properties are driven by the current market and affected by changing business conditions. In addition, they generate only rental income and require a substantial stake. Because of these characteristics, the venture should be leveraged across multiple vehicles to remain competitive with other types of investments.
Over the long-term, the affect of negative spread on income property is cancerous. Not only will the cash-on-cash return for the investors be lower, it also means less money for preventive maintenance, capital improvements and marketing. This is ruination for an income property investment. Income property with a negative spread is an investment in a non competitive cash-on-cash return with an overall return-on-investment that carries an unreasonable risk.
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