Low Cap Rates and High Interest Rates Explained
March 23, 2023
By Terry Painter/Mortgage Banker, Author of: “The Encyclopedia of Commercial Real Estate Advice” Wiley Publishers
1997 was a great year for commercial property investors. It was also the first year I started working as a commercial loan officer. If you can believe it, cap rates on multifamily properties averaged 9.5% back then, and interest rates averaged 7.6% according to Freddie Mac. Most of my clients wouldn’t even make offers on properties unless they could get a 10 cap, and some held out for a 12 cap. In those days, the math really worked well for investors. You could easily put 20% down and earn over a 12% cash on cash return which was just expected then. Even though mortgage rates were high, the math still worked exceedingly well, because cap rates where about 2% higher than interest rates. This article is about what happens when cap rates are lower than interest rates during a time of high inflation as it is today.
In my opinion, I don’t think this is a good time to buy. Today, multifamily cap rates in a good neighborhood in a large city are averaging 5% and interest rates are averaging 6.5%. This means you have to put between 40% and 50% down on a loan to earn a meager 2% to 4% cash on cash return. As a result investors have their brakes on and most have no choice but to wait for cap rates to go up and sales prices and interest rates to come down. The math just doesn’t work resulting in buyer demand that hasn’t been this low since 2009.
What compounds this problem is low seller demand, as most would-be sellers are not putting their properties on the market. I have found that most are strong financially and can afford to wait for rates to come down. Also they just don’t want to give up the low rate they have on the property to buy a replacement property that will have a much higher rate. This has resulted in one of the lowest inventories of commercial properties for sale.
Many real estate brokers disagree with me and pitch that cap rates being lower than interest rates is no big deal. They can be quite convincing that this is still a great time to buy. Why? Because if you don’t buy now you are going to miss out on 5 – 6% appreciation annually and a ton of depreciation as well. They point out that real estate has always gone up in value over time which is mostly true.
I disagree. I guess after doing this job for 26 years, and living through 3 recessions, I’ve seen too many investors buying at the top of the market – including myself and then prices falling during a recession. But don’t listen to my opinion on this. Listen to the math.
Let’s start out by defining what a cap rate is. A cap rate is simply the net operating income – which is income less expenses, divided by the purchase price which gives you the percentage the property will be earning if you pay all cash for it, which is the cap rate.
Annual NOI/Purchase Price = Cap Rate
So, if the net operating income is $60,000 and you pay a million dollars for the property, and don’t have a loan on it, you will be earning 6% which is a 6 cap.
Annual NOI: $60,000/$1,000,000 = 6% Cap Rate
So here comes the fun part! I am going to use Freddie Mac’s 2003 actual numbers as an example: In 2003, cap rates dropped down to 8.00% and interest rates averaged 5.83%. As you will see, interest rates being about 2% higher than cap rates created a gold mine for commercial property investors. Let’s look at the math: With a cap rate of 8.0% the net operating income was $80,000 on a million-dollar purchase. Now to make a 1.25 debt service coverage ratio on their loan they only needed to put 20% down which is $200,000, and finance $800,000. Now let’s subtract annual debt service at 5.83% with a 30 year amortization which is $56,512. This gives you a net annual income after loan payments of $23,488 which is a whooping cash on cash return of 11.74%.
2003
Purchase Price: $1,000,000
Down Payment: - 200,000
Loan Amount: $ 800,000
8 Cap Rate = NOI: $80,000
Annual Debt Service at 5.83% - 56,512
Annual Net Income after Loan $23,488
Cash on Cash Return: $23,488/$200,000 = 11.74%
Today this spread is upside down with interest rates averaging 6.50% and Cap Rates on quality properties in a good neighborhood averaging 5.00%. This is totally nuts as you have to put $275,000 more down than you had to in 2003 to earn 9.6% less. Here’s the math!
Today, with a cap rate of 5% your net operating income on a million-dollar purchase is $50,000 annually. Now to make the minimum Debt Service Coverage Ratio of 1.25 — still required by lenders, you certainly can’t put 20% down anymore. You will need to put 47.5% down which is $475,000, and finance 52.5% which is a loan of $525,000. Now let’s subtract annual debt service at 6.5% with a 30-year amortization which is $39,820. This gives you a net income after loan payments of $10,180 annually - (OUCH!) and a cash on cash return of 2.14% Seriously, like someone is going to invest $475,000 to only earn 2% on it?
2023
Purchase Price: $1,000,000
Down Payment: - 475,000
Loan Amount: $ 525,000
5 Cap Rate = NOI: $50,000
Annual Debt Service: - 39,820
Annual Net Income After Loan: $10,180
Cash on Cash Return: $10,180/$475,000 = 2.14%
But hold on! In reality, (I love reality when it comes to real estate deals), don’t you think you should allow something for inflation on the property’s expenses. As lenders during good and bad economic times, we always pencil in an increase of 3%. But with inflation today being at 6.4%, three percent is not going to cut it. You should probably plan on at least 5% don’t you think? Yes, you get it right. Inflation is going to wipe out your 2% earnings and leave you with negative cash flow. Well you can counter this by saying you will be raising rents.
But hold on again, according to Fannie Mae’s 2013 Multifamily Outlook Report, rents are only expected to go up by 1.5% in 2023. I think they could increase by as much as 3%. So, as you can see, it is a disaster for investors to buy today when cap rates are so much lower than interest rates.
In my opinion, I would wait until the math works better. I predict that towards the last quarter of 2023 that prices will come down as more sellers have to sell due to loan maturity, divorce, partnership breakup or death. These life occurrences always happen. But it looks like rates will stay high as the Feds raise rates further until they can curb inflation down towards their benchmark of 2%. Ideally, you want to buy when cap rates are at least equal to interest rates, and much better when cap rates are higher than interest rates.