Is it possible to make money investing in commercial real estate when cap rates are lower than interest rates? Discover the answer to this important question, plus a case study that demonstrates a simple but effective strategy for investing in today's commercial real estate market:
Correlation Between Cap Rate and Interest Rate
It is extremely important that investors understand the correlation between the cap rate and interest rate so they can make wise investment decisions in today's commercial real estate market. However, first we must define cap rate and interest rate.
Capitalization Rate: Your return on investment as if you paid all cash.
To calculate the cap rate you use this formula: NOI divided by the purchase price. For example, you purchase a million dollar property free and clear of all debt. After you have collected all the rents and paid your expense, your net operating income (NOI) is $100,000. To calculate the cap rate, you divide $100,000 by your purchase price of $1 million, which equals 10%. So that's a 10% cap rate as if you paid all cash. Remember, there are no loans involved.
Interest Rate: The amount you're charged to borrow money.
How the two correlate is that the larger the spread between the cap rate and interest rate, the higher your returns. Historically the trend has been cap rates dropping slowly as interest rates are slowly increasing. However, the peak spread we've ever had was during COVID and it was because interest rates had dropped dramatically, while the cap rates continued to slowly go down. So, the greater the spread between the cap rate and interest rate, the higher the cashflow and ROI. This is one of the reasons investors were making a killing during COVID.
Fast-forward to today and interest rates have gone through the roof while cap rates continue their slow downward trend. Because the Feds raised interest rates so high, there's a dissection point where the interest rates became higher than the cap rate which means now there's no spread. So, how can you make money? Are you going to lose money on your investments? Do you live in one of these cities today where the cap rates are lower than the interest rate? If you do, you may see this correlation and you are paralyzed, unsure how to move forward. You're stuck because you are looking at the situation and wisely wondering if you can make any money in this market.
Case Study - Multi-Family, Big City U.S.A.
This case study will help investors move forward by answering two important questions: Can investors make money when cap rates are lower than interest rates? Or should investors just wait until interest rates come back down before investing? This example deal is in Big City, U.S.A. where commercial property is expensive and the cap rates are lower than the interest rate. As an investor, are you going to lose money in this scenario or can you make money?
Property: $2 million apartment building
Interest Rate: 6.5%
Market Cap Rate: 5% - What other comparable properties are selling for in this market.
Deal Cap Rate: 5% - Your deal cap rate is your NOI divided by your sales price. The NOI is $100,000, purchase price is $2 million. You divide $100,000 by 2 million which equals a 5% cap rate.
(Note: There is a distinction between the market cap rate and deal cap rate.)
Can You Make Money on this Deal?
Absolutely! Let’s make an extremely conservative estimate that you will raise the rents 5% a year for the next five years. (This is possible in any market) Over the next five years if you can raise the rents 5% a year for the next five years, you will increase your NOI to $127,000 by the fifth year.
Year 5 Value: Your NOI (127,000) divided by your cap rate (5%) equals the new property value. The value of the property by year five is $2.55 million.
In addition to creating $550,000 in forced appreciation, you will also:
- Pay down your loan by $100,000 in the next five years. You can add $100,000 to your increased value which gives you $655,000 in appreciation.
- You can depreciate the property about $44,000 a year for five years. That's a savings of $220,000.
- You're going to have other tax write-offs that you can add to this.
Don't wait! If you had waited for interest rates to go back down you would have missed out on $655,000 in forced appreciation and all these benefits.
When investing in the current market, you need to be smart and consider certain factors:
- Sales Comps: Pay attention to what other properties have sold in the area so you have a basis of what to offer.
- Location: Where the property is located is important. Cap rates differ in different areas and some places have more appreciation or higher stability than other locations. You know the old saying, “you can change your property, but you can't change the location”.
- Asset Type: Most of our deals are multi-family because we believe it has less risk.
- Hold Period: Commercial real estate is a long game. You beat the market when you create massive wealth in commercial real estate by thinking long term. One of our students held onto his property for five years and made almost a half million dollars. You can watch my interview with him and see the benefit being a good operator and holding onto a property: $445,000 Profit on a 6-Unit Apartment Deal. There's no short-term outlook in commercial real estate investing. It's precise planning and execution.
Beat High Interest Rates and Low Cap Rates with Creative Financing
One essential strategy you can use to counter high interest rates and low cap rates is creative financing. I have a teaching called Commercial Real Estate Creative Financing that you can watch to discover the top 5 creative financing techniques. These techniques will enhance the net cash flow and cash on cash returns, especially in a rising interest rate market. Don’t wait on the sidelines and miss out on all the benefits of investing in commercial real estate. Apply these creative financing commercial real estate techniques with someone by your side to do them right. Learn more about our Protege Program here: https://www.commercialpropertyadvisors.com/protege-program/