Why CAP Rate Isn’t Everything

There’s a lot of hand-wringing by investors that cap rates are not as good as they were.  That’s true.  If you’re a landlord looking back to glory days of 2006, you’ll remember readily obtaining properties with CAP rates in the 7s.  Currently you’re more likely to see something with a CAP rate around 6%.  Is that 7% CAP rate really better?

Borrowing Costs Are Lower

One thing investors don’t often consider is the fact that borrowing costs have dropped faster than CAP rates.  As a result, it’s more profitable to be a landlord now with a 6.1% CAP rate than a 7.4% CAP rate purchased in 2006.  The spread between CAP rate and borrowing cost makes a huge difference.  Investors should not look at the CAP rate in a vacuum.  The only time this is not true if you have an all-cash buyer, which is pretty rare for long term buy and hold.

CAP Rates Today

This chart shows how a CAP rate today that’s more than a full percentage point below the 2006 CAP rate will provide significantly higher cash-on-cash and five year after-tax returns.

20192006Change
Cap rate for rental 3BR/3Bath/1 Car
Townhouse in central Aurora
6.1%7.4%1.3% worse today
Borrow at3.75%
5/1 ARM for non-O/O
7.0%
5/1 ARM for non-O/O
3.95% better today
Spread (Cap-Int Rate)2.35%0.40%1.95% better today
Debt Cover Ratio146%123%Today's loan is less risky
Year One cash-on-cash return7.2%5.2%2.0% better today
5 Year after-tax return (IRR)18.3%16.8%1.5% better today

Both cases have the same assumptions for annual appreciation (5% per year), vacancy (5%), property management (8%) and maintenance reserves (8%).  Based on actual investor purchases on the MLS.

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