Can investors makes money in commercial real estate when cap rates are lower than interest rates? Discover how to beat high interest rates and low cap rates, why understanding the correlation between the two is so important, plus a case study that demonstrates a simple but effective strategy for investing in the commercial real estate market today.
Cap Rate and Interest Rate Defined
Investors need to understand the correlation between the cap rate and interest rate if they want to make wise investment decisions in a commercial real estate market like we have today. To do that, we need to define what the cap rate and interest rate are. The cap rate is your return on investment as if you paid cash. To calculate the cap rate you simply divide your Net Operating Income (NOI) by the purchase price. For example, imagine you buy a property for $1,000,000 free and clear of all debt. Then, after you have collected all rents and paid the various expenses, your NOI is $100,000. Your cap rate would be $100,000 (NOI) divided by $1,000,000 (purchase price), which equals 10%. So, the cap rate in this example would be 10%. The interest rate is of course the percentage you are charged for borrowing money.
Understanding the Correlation Between Cap Rate and Interest Rate
Now, the question is how do these two correlate? Well, the larger the spread is between the cap rate and the interest rate, the higher your financial returns will be. Historically cap rates drop slowly as interest rates increase. During COVID we saw something unusual where the spread bucked the trend as interest rates dropped dramatically while cap rates continued to drop slowly, allowing investors to make a killing during COVID. If we fast-forward to today, what do we find? Interest rates have gone through the roof while cap rates continue their slow downward trend. Since the Fed has been raising interest rates higher and higher, a “dissection point” has emerged where interest rates have gone higher than cap rates eliminating the spread.
When this happens, how can you make money? The truth is many who live in one of these cities in the US where the interest rate is higher than the cap rate are simply paralyzed by the correlation – what do you do now? How can you move forward without losing your shirt in a market like this? You’re stuck because the math simply doesn’t work, and it seems there is no way to make money in a commercial real estate market like we are facing today.
Case Study: A Multifamily Investment in A Big US City
This case study can help you as an investor decide whether you can make money in a market where cap rates are lower than interest rates or if you should hold off until interest rates come back down. For this case study we’re looking at a deal in a major US city where the cap rates are lower than interest rates and commercial property is expensive. When we calculate the numbers, you will see that a shrewd investor can make money.
Property: $2 million apartment building
Interest Rate: 6.5%
The Market Cap Rate: 5% – What other comparable properties are selling for in this market.
The Deal Cap Rate: 5% – Your deal cap rate is your NOI divided by your sale price. The NOI is $100,000, purchase price is $2 million. You divide $100,000 by $2 million which equals a 5% cap rate.
Can You Make Money on the Deal?
Yes! You most certainly can make money, and here’s how. First, let’s assume a conservative estimate for raising rents by 5% per year over five years which is possible in any market. If you do this, you will increase your NOI to $127,000 by the fifth year. Divide your NOI of $127,000 by your cap rate of 5% and you get a new property value of $2.55 million.
So, not only have you created $550,000 in forced appreciation, but you also payed down your loan by $100,000 over five years, adding another $100,000 in equity to the value of the property giving you $655,000 in appreciation. Furthermore, you can depreciate the property by about $44,000 per year over the five years, saving you $220,000. And that’s not the only tax write offs you will have. In other words, don’t be paralyzed and miss the opportunity to invest in commercial real estate just because the interest rates are high. In this case, you would have missed out on $655,000 in forced appreciation plus the other tax benefits.
Always Invest Strategically
The key is to invest strategically no matter what the market conditions. But to beat the current market, here are 5 factors to consider:
- Sales Comps: Pay attention to what other properties have sold for in the area so you have clarity on what to offer a seller.
- Location: Location is always important, but especially in the current market. Commercial real estate is market dependent, meaning prices and cap rates are different in different areas. Some areas have more appreciation and higher stability than other areas. There is an old saying, “you can change your property, but you can’t change the location”.
- Consider the Type of Asset: In a risky market, less risky investments are key. In the current climate, most of the deals I am interested in are lower risk multifamily buildings.
- Think About Your Hold Period: Investing in commercial real estate is rarely a sprint; it’s a marathon. The way you beat the market is to create wealth over the long term. Like the case study, $655,000 appreciation doesn’t come over night.
- Creative Financing: One strategy that can help you beat high interest rates and low cap rates is to employ creative financing. This includes things like using a master lease agreement, have the seller carry the first or second mortgage, using a contract for deed, or even installment sales. Creative financing in commercial real estate has always been an important skill but is even more important in today’s high interest rate market.
