Clara Investment Group

Navigating the Cap Rate Spread

December 01, 2023

What is the Cap Rate Spread?

As discussed in previous articles, the two major advantages of real estate investing over other asset classes are tax benefits and leverage. This article focuses on leverage, specifically the spread between the cap rate and interest rate on an investment, referred to as the “cap rate spread.” As a reminder, the cap rate is your annual return (net annual income / price paid for the property) without considering the debt. 

For example, if your cap rate on a property is 5%, and your mortgage interest rate is 3%, you have a positive 2% spread. This positive (or negative) leverage concept is fundamental in finance and highly relevant in real estate. Leverage can amplify both returns and losses, making it an essential ingredient to your real estate strategy. 

Why it is more important today

The challenge is that, with interest rates reaching 20-year highs, obtaining a positive cap rate spread has become increasingly difficult. For instance, if you purchase a single-family investment property with a 7-8% interest rate (typical in 2023), the property cap rate needs to be above 8% to achieve positive leverage. However, such properties are hard to find unless you’re buying in C-class or lower-rated areas, which can be challenging to manage and often have lower appreciation.

As a result, many investors, both active and passive, find themselves facing negative leverage in their deals today, a situation that can carry significant risks. Unfavorable leverage dilutes returns, and excessive negative leverage can lead to disaster. A money pit essentially.

Illustrative Example:

Let’s consider a straightforward example involving a $500,000 single-family property with an 80% loan ($100k down) over 30 years at different interest rates:

  • Deal 1 represents the conditions of 2021 when interest rates hit rock bottom. The 2% cap rate spread results in a $590 cash flow, providing a significant buffer for future maintenance or vacancy issues. While a 7% cash-on-cash return isn’t a home run, it allows you to hold the property indefinitely, through market ups and downs. Cash flow is the glue that allows you to hold the asset, pay down the mortgage, and let the property appreciate. You are in control.
  • Deal 2, with no cap rate spread, offers only a $102 monthly buffer, making it susceptible to unexpected expenses. Accepting a 1% return on cash is unappealing when a money market can yield 5% (in 2023). While you still enjoy potential appreciation and tax benefits, the foundation of your investment is shaky.
  • Deal 3 represents the worst-case scenario, with negative leverage. This isn’t an asset; it’s a problem. Your only hope is that appreciation and rent growth will rescue the investment long term. Negative cash flow might force you to sell the property at an inopportune time, resulting in a loss. This is speculating more than investing.

Does it Ever Make Sense to “Go Negative”?

I’ve never purchased with negative leverage, but there may be some reasons to consider it. If you know you’re buying below market value (based on comps and appraisals) and you have the reserves to deal with negative cash flow for a limited time, it might make sense. The plan would be to sell or refinance within a year or two.

A second scenario is when you know the rents charged by the previous landlord are below market rates (by thoroughly comparing comps in the area) and you can easily increase them to achieve positive leverage. In other words, you are betting that negative leverage is temporary. For me, I would have to be 100% certain, and I would need to believe there is significant upside to justify the risk. 

One of the key points I focus on when evaluating apartment deals is the assumptions made about rent growth. Many apartment operators are banking on continued rent growth (above the historical average of 3-4%) to bring a bad deal into positive leverage territory. If I see that, I screen them out immediately. We’ve experienced unprecedented rent growth in recent years, but assuming that growth will continue at the same high rate is irresponsible.

So What Can You Do About It?

Besides patiently waiting for cap rates to increase (aka values to go down) or interest rates to fall, there are a few viable strategies to navigate the current cap rate spread reality. 

  • Buy better: The silver lining with higher interest rates is that it can make you a better real estate investor. If you’re forced to achieve a 9-10% cap rate to attain positive leverage on your 7% loan, it raises the bar for what “good” looks like. It’s a great time to hone your deal-hunting skills and rethink your strategy. For example, one sector I’m focused on is short-term rentals because achieving higher returns (+8% cap rate) is more attainable. On the passive side I’m investing in multi-family buildings that can work as short-term rentals for the same reason.
  • Go back in time! Yes, that’s right. One of the big advantages in commercial real estate vs single family investing is that commercial loans can sometimes be assumed by the new buyer. So even though a new loan might be at 8%, an assuming loan from 2021 might be under 4%. In fact, I’m investing in an apartment in San Antonio with an assumable 3.25% HUD loan, locked for 40 years. That loan structure both reduces risk and bolsters cash flow – providing a nice cushion for investors. You can’t do that with single family investments. 
  • Explore preferred equity: Preferred equity is a lower-risk, lower-reward investment that sits between common equity and debt within the investment capital stack. As a preferred equity holder, you get paid before the common equity holder, providing more downside protection for your investment. However, the upside is typically capped as well, so you won’t benefit fully if the deal becomes a massive success. These deals typically offer annualized returns of 10-15%. I’d still require a positive spread, but if you want to participate from a safer entry point, preferred equity could be a suitable choice. 
  • Good time to deleverage? For existing investors, it’s a good time to evaluate your portfolio from both a return on equity and debt perspective. For example, my mortgage interest rates on properties range from 2.65% to 8%. At the same time, some of my properties have appreciated so much that my return on equity today is only around 3%. So, I am selling those 3% return homes to pay off those 8% loans. I’m also investing with no leverage in some cases with a plan to leverage back up when rates improve.
  • Be opportunistic: It’s also a good time to be flexible with your investment strategy given the potential coming storm with commercial real estate. There will be discounted properties in need of capital injections, whether through notes, preferred equity, or common equity. Some properties will be available via foreclosure as well. Institutional investors and lenders are pulling back, which opens up opportunities for smaller investors to step into the liquidity crunch. It’s a great time to have dry powder available. 
 

In short, understanding the cap rate spread and its importance is essential to navigating the current real estate landscape, particularly with rising interest rates. Making informed decisions and considering alternative strategies can help investors adapt to changing market conditions and stay on top.

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