Christian Osgood and Cody argue that cash flow, not cap rates, drives real estate returns. They show how a $100 rent increase builds equity, stress the importance of borrowing below the cap rate, and use the Debt Service Coverage Ratio to ensure properties survive rent drops.
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Hello again, YouTube. It's Christian and Cody. We are back, and this week we are talking about why cap rates don't matter. I know that sounds crazy, but Cody talked about this a little bit last week in his interview on BiggerPockets, why we don't focus on cap rate, and it got a lot of feedback. And so it's something that we wanted to address this week in a quick video to you. Cody, why are cap rates not our focus?
Well, I Just before we jump into that, cap rates are not our focus, yet they are vital to making money in real estate. I want to put that out there. In the real estate space, when you're talking 5+ multifamily or you're talking storage facilities, we're looking at dividends. We're looking at what is our actual net cash flow. And we refer to this with net operating income. This is after you pay your taxes, your insurance, your— to it, utility bills, your management fees. This is what you would actually get paid if you own the property outright. And when you can increase that number, maybe you get more efficient, you cut expenses, or you get new income, you make a return. You get your cash flow up when you pay it off, and then if you were to sell it, it's worth a little bit more to the next person because they can pay more and get the same return you did when you bought it. Just by creating efficiencies or getting new income. And if you think about this like a piece of pie, you bought a piece of pie, you got your little circular pie pan, and if you're going to sell that to someone else, if you give them less of the pie, you get more. And it's the same with the cap rate. If you give someone a lower return next time, a lower cap rate than you bought it on, You get more, you get more money. It's the same with real estate and equity. It's all about numbers. So in this case, let's say you increase rent $100. Just do this exercise, write it down on a piece of paper. $100 a month is $1,200 in a year. That is new income. Well, just because you raised around $100 doesn't mean your utility bills go up. Yeah, which is a beautiful thing. You get new $100 that you can blow on anything you want. Well, if you sell that, The next investor is going to get that same $100 that you would. So if you take your $100 a month, multiply by 12 months, you've got $1,200. Divide that by your cap rate. Pick any cap rate you want. You do a high cap rate because people love high cap rates. 8%. You're going to make $15,000. Yeah. Woo! Per unit. If you got 10 units, you just made $150,000 by raising $100. But what if you did that on a 6% cap rate? Now you make $20,000. You just do the math. $1,200 divided by 0.06, you made $20,000. And if you did that on a 4% cap rate, now you make $30,000. But we don't buy just for equity growth. We're buying based on cash flow. And so what do we have to do when we're borrowing money, Christian?
Well, when we borrow money, we have to make a spread. You need a low enough interest rate to make a spread between what you're borrowing and what you're making in cash flow. Otherwise you're going to be cash negative.
And this is why we do the seller finance rate. We can name whatever our interest rate is and it allows us to go get more creative deals. We can make them cash flow ridiculous amounts for very little money down and we can buy a little bit lower cap rate, which allows us to multiply our money further and build our equity up because we want to have 30 to 40% equity in every property. But the only way we can do that is we can go get mismanaged properties. We can buy them for little money down with seller financing. We can get the rents up, we can get the expenses down, and now we've got a, not only a ton of cash flow, but a ton of equity that we can roll up and up and up. But the main thing is you have to be able to borrow cheaper than your cap rate to make that spread.
So now your question becomes the two metrics I do care about. It is How do I own it? And how do we never lose it? How do I own it and how do I keep it? So how do we own it? That's all relationships, right? And that's where you can negotiate everything when you use seller financing. Every single term is custom. Anything you can imagine and you can get the lawyers to sign off on, you can do. And we can get creative on partnerships too and how we structure the equity side. But as long as you have that level of creativity, and the numbers work and it cash flows, you get to keep it. We need a margin so if we have economic disaster, rents pull back a little bit, which is unlikely but it happens from time to time. If rents pull back, do we have enough cash flow to cover that? If values go down, as long as we don't sell, we don't care. So if the value is down and we hit a down market— market goes in cycles— we don't have to sell it. We continue to cash flow. We are paid to wait. So if we can own it in an area that we love, that's likely to appreciate, we can make money on appreciation. Tenants are paying the debt, we're getting the debt paid down. Those things are covered by where we buy. Buy smart, choose your market, know your market. But ultimately, once you know where you're going and you've stacked the deck in your favor, can I own it?
Can I keep it?
If you can do those two things, those are the metrics we care about.
And to dive a little bit deeper into that on the numbers side, I made a video about this in the past. DSCR, you're looking at your debt service coverage ratio. When you're investing, you should look at ratios. We can drop our rent 30% and still cash flow. And that is a metric that I would keep in mind when you're investing. Yeah, it's great getting all the cash flow checks today, but if something goes wrong, it's good to know that you're going to be fine because as soon as you have to start feeding that property, you know, how many properties can you do that for? I can't do it for 81 units. So I had to make sure that I could have a huge adjustment. And so if there's something you want to check out, you should check out the DSCR video. But talking on cap rates, you make more equity when you buy on low cap rates. That's why a ton of people make a ton of money in Seattle and California. The problem with it is you have to figure out how to borrow cheaper than that for long periods of time. And so if you're figuring out whether you should go to the 8% cap— our video cut out, and so we are Just wrapping this up, whether you're buying on a 4% cap rate or you're buying on an 8%, you need to have margin between your loan interest rate and the cap rate. So if you're borrowing at 4%, you probably shouldn't buy a 4% cap rate deal. You're not going to make a margin. So that said, if you haven't already, you should subscribe. Let us know in the comments below what you think about this, and we're going to keep working on this YouTube thing.
And if you haven't checked out Cody's video yet on BiggerPockets, That dropped, what, early, late last week? Whenever that dropped, go to BiggerPockets, check that out, learn more about Cody's story. Like and subscribe. Talk to you soon.
