What is a Cap Rate? Why Cap Rates DON'T matter!!! Multifamily 101

Hello YouTube, it's Christian. I'm back with Brandon Vukelic. This is Multifamily Investing 101. We're going over some of the basics, and one of the main things that we get asked a lot about is cap rates. Now, while cap rates are a huge piece of real estate, you're going to hear it all over the internet, I don't personally care much about cap rate. It doesn't, doesn't really affect me. So today I want to talk to a couple of multifamily millionaires about what they think about cap rates, what are they, and is it something that you actually need to be concerned about? So have Brandon back here. Brandon, welcome back to the channel. Yeah. Good to have you.

Thanks.

How would you define a cap rate? Just mathematically, quickly, what is a cap rate?

The quickest way is a capitalization rate, right? If your property makes $100,000 NOI and you paid $1 million for that, that's a 10% cap rate, right? So you pay $1 million cash for that property, throws off $100,000, 10% cap. So cap rates really only apply to more commercial property. You know, we know there's a 5 units or more or industrial office warehouse stuff. I don't really personally teach it too much on duplexes and triplexes, and we're more concerned about the cash on cash return more than anything, right? How that property is going to perform positive cash flow.

Yep. Now if you're trying to break down to its simplest form, the net operating income is just your net expenses— or sorry, your net income minus your net expenses. You don't include debt in that because debt is variable to each deal. It's just the operating cost of running your building. You divide that by the purchase price and you get a cap rate. Essentially all it is is that is the return that an investor would expect in that market if they were to buy the deal in cash.

And it's a level of risk, right? So we know, particularly in our area, the Seattle-Tacoma-Puget Sound region, we have low cap rates, right? Because very desirable, very growing, stable economy, high rent growth, high appreciation. So there's lower risk. If you, if you see higher cap rates, it's usually a higher risk market, maybe tougher demographics or something like that too.

Now, if you're buying money just to passively park it in a property, just absolutely hands-off investment, cap rate may matter a little bit to you. If you are an active investor like I am, I don't care at all. Our biggest deal that we've done to date is the 38-plex that Cody and I took out early in our career. We bought that on a -1.5 cap and actually lost money operating because they had so many non-paying tenants.

But you weren't going to own it for a year?

No. If you're going to own it forever, there's only two questions that we ask in an analysis. It's how do we own it, which is what is the actual opportunity and what do the sellers need, and how do we never lose it. If I'm never selling it, I don't care at all what the cap rate's for. Now, if you're going to refinance with a bank, knowing your market cap rate does make some sense because you have to use math to figure out say you have a 5-year balloon. If the plan is to refinance with a bank, which is another thing Cody and I don't do, what are they going to value it at?

Right.

And so that may come into play. And so you need to know what things are selling for in your market. And there's two pieces of math you do. You're going in, which is what does this property actually look like today? Using really conservative numbers, assuming that vacancy is a little bit higher, you have a few problems.

There's always surprises.

Yeah, factoring for surprises. What does it look like today? And then whatever your exit is, whether that's a sell, refinance, you need to do the math for what do we project to then. And again, on conservative numbers, assume cap rates have gone up a little bit and you have more vacancy than you have today. If you can do that math and you have a plan for this is how I own it and this is how I never lose it, that's all I care about, right? Like today, we bought a 38-plex that was making $6,000 a month. 10 months later, that property makes $28,000 a month. It's awesome. And we're going to keep holding it, and that will continue to increase. That's, uh, that's actually pretty low rent for 38 units in Washington State. So, and the market's kind of weird right now, you know, we're—

this is September 2022 as we're speaking right now. Uh, rates have spiked, uh, but there's still a lot of demand for multifamily, and cap rates are still kind of low. So you're looking at some properties that may have a 4, 4.5 cap, but if you're looking to finance that thing, you're looking at 5.5, maybe even 6% on the financing. So you've got a negative yield there, which is a problem, right? And the lenders are going to ask you, it's not the typical 25% down, they're looking for more, 55, 60% LTV, which is not the best deal in the world.

Yeah, you have to end up putting a lot of your own money in those deals if you want to take them out conventionally. Now, Cody and I don't play with banks. I have one property right now that has debt with the bank, and that's that first duplex. Nothing else is in bank debt for us. And when we refinance, I personally prefer to use new private capital, even if it's more expensive, just to not work with banks. I don't like them. I don't like the way the industry works. And if you do great deals, you don't have to. I can actually borrow at a little higher rate when your properties make enough money to support that debt. So for us moving forward, I don't really care about cap rate. I do care about how is this property going to operate, a metric that I think is much more interesting. Cash-on-cash ROI.

Yeah.

Now I think most of the cap rate, IRR, whatever, the alphabet soup of stuff belongs in the alphabet. It doesn't belong in your portfolio. However, that is one metric that I do look at. What is the actual cash flow from this property day one, and where is it going to be again at, uh, you know, 3, 5, 10 years from now? What are we expecting? So, Brandon, when you're buying, what do you look for in that?

Yeah, I'm trying to see how long it's gonna take to stabilize, right? We know, again, I'm not buying it just to hold it for a month or a year. So the numbers may look like crap 6 months, 12 months out, but I know I'm gonna get that thing stabilized and it's gonna throw off a projection that I'm expecting 7, 8% cash on cash, right? Something better than that if we can. I only recognize cap rates because I know it's a big term that kind of floats around on websites and everything and BiggerPockets and investors come to me looking to buy small properties or like wondering what the cap and I really don't touch on it too much for them You know, focusing on that cash-on-cash return is like the most important thing in my opinion.

Mm-hmm. 100% agree. A target that I started with is 8% is what I target as far as what the cash flow looks like for me. If you're bringing in additional capital and additional partners, I just look, is my return on this 8% or greater? Even if it's on someone else's money, that's the cutting off point for me where I'm like, there's enough cash flow in this deal where we could be wrong on a number and still be okay. We have a little bit of an "oh no" fund built in where you can cash flow your way through your problems, and it's going to be worth your time. Now, as you do larger deals, 8% of a larger deal is in fact more than 8% of a smaller deal. So as you start progressing, I highly recommend that you look at the largest deals that you can possibly take down, because more units and more size adds more stability and more cash flow.

And we're never stuck, right? If the deal doesn't work, maybe, maybe doesn't pan out like you expect or project. You know, you're doing the best you can based on the data available today and how things are moving in the market, but maybe that deal doesn't work out as you expected and it's time to dump it.

So practical application, we'll end on this, uh, 7-plex that Cody and I bought in the Seattle market. So talk about low-cap markets. Property was underperforming a little bit, a little bit of deferred maintenance, but otherwise a good property. It was no major projects needed. But way under market rent. So we picked up a property. It was valued on a 5.5 cap by the owner at $1.2 million. I offered to come in at $1.1. We did 4.5% down. Now, if you're trying to increase your cash-on-cash return, if you put in less cash, you're dividing by less cash. Cash-on-cash is simply what is the annual net income divided by your cash in the deal. If you put $50,000 into a deal on a $1.2 million asset, your cash-on-cash typically looks very high. You're getting pretty deep in the double digits on these. However, if I was looking at the cap rate, it was an okay deal. We had, I think, 3 months. We gave tenants a little bit of extra time for the rent bumps. We did some maintenance, we re-graveled, there's landscaping that needed to be done. So we did some improvements. We give them a 3-month ramp up to new rents. If you looked at the cap rate based on where we brought it in 3 months, it's like a 9-cap deal. Yeah, that's solid. It's, it's phenomenal. However, I just am not looking at the cap rates because that wasn't relevant. The cap rate changes if you have a game plan on the property, and if you're never going to sell it, who cares, right? So that property today is spitting out thousands of dollars of cash flow every month. We put very little money down on it, and those are the opportunities that you should focus on. So again, I would just look at how do you own it, how do you never lose it? And you answer that through cash flow and long-term fixed rate debt.

Exactly. Keep doing what you're doing.

Yeah. If you're one of the 27% who are still watching the video, I don't think I mentioned this, but like, subscribe. If you know someone who's stuck on cap rate or who's in analysis paralysis mode, this is the video for them. So share this video with them. One, it will get this out to more people. And two, you might help a friend. So until next week, we will, we'll talk to you later.