Do Properties With Highest Cap Rate Generate Highest Total Investment Return?

Do Properties With Highest Cap Rate Generate Highest Total Investment Return?

By David V. Tran

In most commercial property listings, you often see cap rate listed.  You probably think properties with high cap rates will generate better returns.  However, cap rate alone does not tell you the whole story about total investment return as demonstrated below.

Let’s look at 3 properties: property #1 with 8% cap, property #2 with 7.5% cap, and property #3 with 8.5% cap.  To simplify comparison, let’s assume that all 3 properties are purchased at $3M. 

1. The first property: the lender provides 70% Loan To Value (LTV) financing at 6.5% interest.
2. The second property: the lender provides 70% LTV financing at lower 4.6% interest.     
3. The third property: the lender only provides 50% LTV financing at 4.6% interest.

	Property #1 $3M, 8% cap	Property #2 $3M, 7.5% cap	Property #3 $3M, 8.5% cap
Net Operating Income	$240,000	$225,000	$255,000
Loan to value (LTV)	70%	70%	50%
Loan amount	$2,100,000	$2,100,000	$1,500,000
Down payment	$900,000	$900,000	$1,500,000
Interest rate (5 years fixed)	6.50%	4.6%	4.6%
Annual Mortgage payment	$170,152	$141,509	$101,074
Annual Interest payment	$136,500	$96,600	$69,000
Cash flow	$69,848	$84,496	$153,926
Principal reduction	$33,652	$44,904	$32,074
Total Income before tax	$103,500	$128,400	$186,000
Total investment return	11.5%	14.26%	12.40%

On the surface, property #1 should offer higher return than property #2 due to higher cap (8% vs. 7.5%).  However, the total investment return of equity for property #2 is higher than property #1 (14.26% vs. 11.5%).  This is due primarily to lower interest rate, 4.6% vs. 6.5%.  Why does property #2 get lower interest rate?  There are many factors that determine the interest rate:

·        Loan amount: In residential mortgage if you borrow less money, i.e. a conforming loan, your interest rate will be the lowest.  When you borrow more money, i.e. a jumbo or super jumbo loan, your rate will be higher. In commercial mortgage, the reverse is true! The rate for $200K loan is higher than that of $1M.

·        Loan to Value (LTV): as a rule of thumb, the lower the LTV the lower the rate.

·        Property type: the interest rate for a single tenant night club building will be higher than multi-tenant retail strip because the risk is higher.  When the night club building is foreclosed, it’s much harder to sell or rent it compared to the multi-tenant retail strip.  The rate for apartments is lower than shopping strips.  To the lender, everyone needs a roof over their head so the rate is lower for apartments.

·        Age of the property: loan for newer property will have lower rate than dilapidated one.  To the lender the risk factor for older properties is higher so the rate is higher.

·        Area: if the property is located in a growing area like Dallas metro the rate would be lower than a similar property located in the rural declining area of Arkansas.  This is another reason you should study demographic data of the area before you buy the property.

·        Tenant: single-tenant property with a brand name/national credit tenant, e.g. Walgreens will get a lower interest than Rite Aid.  This is because Walgreens currently has S&P rating of A+ while Rite Aid has B- (just a few notches above junk) rating.

·        Location: the retail center next to Walmart will probably get a lower rate than a retail center shadow anchored by a mom-and-pop furniture store.

·        Your credit history: if you have good credit history, your rate is lower.

·        The lenders you apply the loan with.  Each lender has its own rates.   There could be significant difference, e.g. over 1%, in the interest rate for the same property.     So you should work with someone specialized on commercial loans to shop for the lowest rates. In 2010 where the credit market is very tight. There are fewer lenders out there willing to provide any financing. If you apply for a commercial loan yourself, chances are you will pay a higher rate because you apply for the loan at the “wrong” lender.

·        Prepayment flexibility: If you want to have the flexibility to prepay the loan then you will have to pay higher rate. 

If lower interest rate is the reason why a lower cap property has better total investment return then why does property #3 with highest cap of 8.5% and the same interest rate have lower return than property #2?  The answer is property #3 has lower LTV.  When the interest is lower than the cap rate, you also make a profit on the money you borrow.  So the more money you borrow, i.e. higher LTV, the more profits you make.  And you think you should be able to Google for the banks with lowest rate and highest LTV.  In 2010 the credit market is very tight, many lenders hold on to the cash they have.  Those with money to lend want highest rates.  They want to keep the LTV in the 50% range.  To complicate this matter further, two lenders may offer the same rate but different LTV, e.g. one lender offers 50% LTV while another offers 70% LTV to the same Walgreens drugstore.  So besides high cap properties, finding a lender that offers lowest rate and highest LTV is critical. 

Conclusion: If one of your investment objectives is to achieve highest return of your equity, cap rate alone is not the answer.  You also need to get the lowest interest rate and highest LTV.  Most investors don’t have the knowledge to get the lowest rate and highest LTV for their loans.  And so you should not attempt to do it yourself.  You should work with a broker with knowledge & experience in both commercial real estate and loans.  He/she will advise you which property, at which location, with which tenant, and which lenders will deliver an investment with highest returns.  Otherwise, you may end up screen out the properties that meet or exceed your investment objectives.

 

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