Math on spread between mortgage rate and cap rate in calculating (rough) MF profitability?

TangoWhiskey

Frequent Forum Member
Registered
I've often heard it said the fundamental is the spread between borrowing and cap rate on multi family. How would the math work?

assume 2 million $ purchase of building generating 20K gross rents in smaller community at a 6.75 cap

85 % CMHC mortgage of 1 700 000 at 1.75 % rate = monthly payment of 8750

This is a 500 basis point spread between cap rate return and borrowing cost which is huge ... but how would the math work?

At 6.75 cap working the typical math backwards on a 2 million $ deal that makes the NOI 11250 which would give an expense ratio of 43.75 %, which isn't out of line with for example a bldg where tenants pay lights but water and heat is included... but I don't really know how or what the quick and dirty equation is to figure out return based on the spread between cap rate and mortgage rate.

Is it that for each million of mortgage $$ borrowed that you are making 50K (500 basis points or 5 % X 1 000 000) per year in cashflow not counting paydown?

Thanks, input from the heavy hitters appreciated.
 

Thomas Beyer

Senior Forum Member
REIN Member
Correct in principle. Also let’s not forget R&M and ongoing capital upgrades that’ll eat into your operating cash-flow.

You can’t usually get 85% either. Let’s use 75%. What is better: Cash-Flow or Maximum ROI ? http://myreinspace.com/threads/what-is-better-cash-flow-or-higher-roi.26596/

Cash-flow does NOT make you rich, but it allows a sustained ownership. Appreciation and mortgage paydown (by others) is where you get wealthy. [btw: A market with no upside - especially as a young person - ought to be avoided in my opinion. ]
 

Matt Crowley

Senior Forum Member
REIN Member
Good question.

6.75% cap would only exist in a small town or city setting right now in Canada.

NOI considers all operating expenses with the exception of cap ex (roof replacement, repaving parking lot, ect).

Cap ex is typically measured as a % of NOI. NCREIF has good studies on this sort of thing. Historically (and before historically low cap rates), it was in the range of 15% of NOI towards cap ex for MF.

So take your 6.75% cap rate less 15% = ~5.75% cap rate yield effective. On a lower quality asset like this (based on the cap rate), interest rate would be more like 4% so 275 bps spread.

Cash on cash return is just the leverage ratio so take 275 bps / (1 - leverage). If 70% leverage then 275 bps / 0.3 = 9.2% cash on cash return per year....roughly.
 

TangoWhiskey

Frequent Forum Member
Registered
Thks Matt. Great info on the 15% historical cap rate reduction due to capex. I didn't know that stat.

A heavy hitter response
 

TangoWhiskey

Frequent Forum Member
Registered
Watching the vote counting here and running the numbers you just taught us ... So on a 300 basis point spread bldg on an 85 % cmhc refi mortgage that would mean a cash on cash return of 20 % ... assuming the equity left in at refi was actually the market value and the necessary investment to close.
Which lines up with personal experience. Added to the extreme leveraged paydown ratio on cmhc mortgages the wealth creation is v effective.
 

CorySperle

Senior Forum Member
REIN Member
What the spread analysis ignores are the realities of how wildly your NOI can fluctuate. For example chances are if you owned a building in Alberta purchased in 2014, and had to renew in 2019 you faced the very real possibility of not only having no equity, but possibly even having to pay the loan down, and in some cases a forced sale at a lower value. Exasperating this example is the fact that during that same 5 years not only have rents fallen, expenses are up drastically especially in terms of insurance and property taxes, as well as cap x that has been mentioned above. Your spread is negative and in many cases you have lost money, so buying a building today with this metric alone is like playing with fire.

Many of us are used to the days of annual rent increases, and modest expenses, and predictable and stable NOI over the 5 years, and even massive equity take outs even for substantial C class walk up buildings. Things are much less clear today, and it is tougher than even to make any money on older walk ups and they should only be considered for investment purposes if they can be obtained significantly below market value and/or with value add and upside potential. Unfortunately the popularity of this asset class has soared, especially with the collapse of retail/office so there are many newbies out there chasing what few assets there are.
 

TangoWhiskey

Frequent Forum Member
Registered
Another heavy hitter response ... Cheers.
Isn't the avoidance of refinance risk the real value of CMHC? Added to the outsize paydown returns due to the low interest rates and the fact it is a self-financing policy?
Let me know of any holes you see in this plan:
I focus very specifically on two small towns in East Coast markets where 85% CMHC mortgages still happen. The goal is to end up with 5 cmhc financed buildings with ideally 1.5- 2-3 mill mortgages staggered to have 1 mortgage renewing every year in the 5 yr cycle to allow harvesting of the current ultra-high paydown ratios that are now paying down something like 100% of the 15% equity left in each building on a 5 yr term if it was BRRR'd, which is typical of my bldgs. Essentially it's a 6 to 1 leverage play on mortgage paydown with strong cashflow to enable waiting and low capex hopefully as most units should be newish.
If I market primarily to retirees and govt employees I buy maybe a year of higher occupancy should the worst happen and some unforeseen series of events kill employment and rental rates thus killing value. At renewal time my understanding of CMHC insurance is that the risk free mortgage renews without risk of the bank requiring further capital injection. So theoretically I don't have any net worth or other issues to face forcing a cash call to restore equity ratios.
Is my understanding correct? Do you guys see issues with this plan?
The biggest downside I see in this plan is knowing at exit my buyer pool is small due to the small town locations with maybe a 1-2 year wait for the right buyer.
Also the risk the downturn happens before the final BRRR and refi.
I have the 5 bldgs now. only 3 are so far in cmhc money and covid has had the ridiculous effect of lots of contractors losing guys to the 2k per month govt handouts to work for themself on the side. So right now I have a stalled 4th bldg brrr with 9 gutted units in a 16 unit bldg due to lack of labour, hopefully labour availability comes back by Xmas when all the govt workers now with time off sitting at home stop hiring them. Covid has created some real winners along with the losers and govt unions are probly highest on that list, they work less and get paid even more - danger pay. True.
I looked at buying Texan MF in 2012 when I only had 1 bldg and realised anyone who had bought in 2007 at market peak .. If they had survived to 2012 ... was being crushed and bankrupted by equity calls at 2012 renewal. That kind of drove my thinking on how to plan to be very defensive - two small towns an hour apart make it mgmt efficient with my nuclear worst case fall back being I can always let the mgmt go, sell our low debt residence to raise cash and move into a 3 bed unit we keep for this reason in the nicest complex and slash both living and operating costs waiting 4-5 years for the turn around. Don't ever want to but I saw people having to do that in Texas and then still losing their bldg as they hadn't planned their worst case position. I think my plan should hold down to about 75% occupancy if I start doing all the maintenance myself if I had to.
So I appreciate you guys pointing out any holes or risks you see in this plan and or things I'm missing. The 2 towns are in good fiscal shape and regional centers in their own right.
Thks
 

Thomas Beyer

Senior Forum Member
REIN Member
Yes a 25,30 or 35 yr amortized CMHC policy is worth gold.

Needs a good PM incl maintenance team on the ground though. A good PM has numerous contraries on speed dial.

You pay peanuts you get monkeys though !!


Sent from my iPhone using myREINspace
 

Martin1968

Frequent Forum Member
Registered
The problem with calculations like you mentioned, points, spreads, cap rate cap ex you name it, is how to equate this to hard dollars. The first 4 you can’t deposit into your bank account, but hard earned dollars you can.

Seems to me that all these calculations are out the window and make no sense when you state that you run at 75% occupancy rate. (Seems that particular part of your post was removed?) Cashflow in apartment buildings, such as you own, is small as it is, running at 75% capacity with high mortgage ratio (85%) and no equity (15%) is deadly. I would really take Cory’s post to heart, after all he is a ‘heavy hitter’ on such investments.

Thomas says something about cashflow, and although I don’t disagree, you gotta keep in mind that for someone like you that’s a FT RE investor, wanting to make a living of your investments, cash flow is a bit more then just Queen. It’s a little more then being able to afford sustained ownership. You also have to look after your wife and kids after all.

Furthermore, 9 out 16 units gutted in a building and no activity or hardly any till Christmas? ouch! Are you saying the contractor you hired is paying his workers less then the 2K CERB per month?
Time to fire that contractor and hire the CERB workers on your own account to come work for you.

You also stated in one of your post that you market to seniors and government workers? The first one, there might be plenty of in smaller towns but often on low fixed incomes. The second ones, government workers, seem harder to come by. I would seriously advice to broaden your limited selection criteria and get that 75% occupancy rate up to 100%

In all honesty, I think one should not confuse the total number of doors a RE investor owns as opposed to the profitability of the operation. More doors does not necessarily mean more cashflow or being more profitable.
What is better? Owning a large herd of dairy cows that are underproducing at 75% of their milking capacity or having a smaller herd and turning these into 100% top producing cows.

So to answer your question about ‘spread math’ the only spread I see in your example is a THIN spread. Very very thin........

Kind Regards
 

Matt Crowley

Senior Forum Member
REIN Member
I think Tango posed a good investment question.

Whenever there is discussion of a going-in cap rate that means the stabilized NOI at the stabilized vacancy. Cash flow modeling is always part of the underwriting. But looking at spreads is very commonly done and is a good measure of expected performance.

Lower occupancy or rents ultimately means a lower stabilized NOI and going in cap rate. Looking at development margins and cap rate spreads is common practice across asset types.
 

Martin1968

Frequent Forum Member
Registered
I agree, nothing wrong with the question in itself.
Left answering that part up to you You did well.
 

Thomas Beyer

Senior Forum Member
REIN Member
The key issue with CAP rates is R&M as that value fluctuates, plus CapEx usually not required in an NOI calculation.

Both can bite you. Ensure you know the magnitude over say a 5 year horizon.


Sent from my iPhone using myREINspace
 

CorySperle

Senior Forum Member
REIN Member
I have followed your posts for several years now and you have done very well out east, a market I know little about. It does seem that your market is valued lowered, however stable in that values and rents do not fluctuate as wildly as they do out on the prairies. What you are doing has worked, and seems to be still working quite well utilizing CMHC financing. The two pronged risk of investing out east, and in smaller communities would be too much to handle for most of us, and not sure about your management situation but I'm assuming you self manage and this is your full time gig? Some of the most successful investors I have seen have been in niche markets like Prince George, or other smaller centers which further cements my belief in investing in markets in which you live and know intimately.
 

TangoWhiskey

Frequent Forum Member
Registered
I have followed your posts for several years now and you have done very well out east, a market I know little about. It does seem that your market is valued lowered, however stable in that values and rents do not fluctuate as wildly as they do out on the prairies. What you are doing has worked, and seems to be still working quite well utilizing CMHC financing. The two pronged risk of investing out east, and in smaller communities would be too much to handle for most of us, and not sure about your management situation but I'm assuming you self manage and this is your full time gig? Some of the most successful investors I have seen have been in niche markets like Prince George, or other smaller centers which further cements my belief in investing in markets in which you live and know intimately.

I self-manage in one of the communities through an on-site manager, and outsource in the other, but I live in the S of France and have done for 4 of the last 6 years. The high cashflows that small market buildings can produce (3-5K per month per stabilized building is not unusual) added to the leverage of CMHC insured mortgages and a steady 2% annual rent growth can produce incredible results, both in terms of time freedom thanks to cashflow and also the long term results as downpayments are doubled thru paydown on a 5 yr term. One advantage of CMHC is that it allows new investors to be as sure as is reasonably possible with their first building that the building is a good investment - we had never bought any investment property when we bought our first 24 plex in another province using everything we had built up in life to that point. Its the main reason I've never been afraid of well governed small towns - if CMHC signs off on an 85 % mortgage of purchase price, its gone through multiple levels of dd by at least 4-5 people with a lot of experience in this space. Most problems should be solved if I can hold long enough for the outsize amortization to provide for an exit if the cap ex or some other issue turned out to be higher than expected. I didn't really understand at the time what I was learning, but the director of CMHC in Halifax very kindly gave me an hour of his time on a purely random drop-in visit to their office in 2012 and he told me a) the East Coast was the last part of Canada still giving 85 % CMHC financing and b) this didn't exist elsewhere. When I wrapped my head around that I got real focused and we havent had jobs since 2011 other than RE.
I don't know of any form of 6:1 leverage in other investing venues that comes with built in self-financing review and multiple level dd of the opportunity. Its a leverage play both on the mortgage financing but also (I think) the fact a national policy created to manage risk in big city MF results in possible mis-pricing in small town MF, and I suspect thats true nation-wide not just East Coast.
But thanks for your replies to these comments and questions, the risk that eats you is the risk you don't see. So I would appreciate your feedback or thoughts on that quite long outline of what I'm working towards posted earlier in the thread - we are at 94 doors in 5 bldgs in our small town focus. cheers
 

TangoWhiskey

Frequent Forum Member
Registered
I think Tango posed a good investment question.

Whenever there is discussion of a going-in cap rate that means the stabilized NOI at the stabilized vacancy. Cash flow modeling is always part of the underwriting. But looking at spreads is very commonly done and is a good measure of expected performance.

Lower occupancy or rents ultimately means a lower stabilized NOI and going in cap rate. Looking at development margins and cap rate spreads is common practice across asset types.

Thanks Matt. I generally pay almost no attention to cap rates instead focusing on cash on cash return, it was partly through this post that I started to realize cap rates had compressed further - I was trying to decide what cap rate to use to underwrite an upcoming CMHC refinance and the cap ex plan to realise the biggest refi cheque - and even after reducing it further realised it was still 500 basis points higher than the lending rate, a huge spread - and that prompted the question in the first place.
I've appreciated your deep knowledge and understanding of this space, along with the other replies here.
 
Top