A real estate investor recently asked the following: “I’ve noticed that most if not all properties in my area offer a cap rate of 3.5%-5.5%, and when I ask the brokers why the cap rates are so low they say it’s ‘perfectly normal’ for this area. Am I missing something here?”

It was “perfectly normal” to buy mortgage backed securities without collateral before they collapsed. It was “perfectly normal” to invest with Madoff before his empire collapsed. It was “perfectly normal” to buy dot.com companies before they became worthless. History is replete with giving comfort to poor investments by considering them “perfectly normal”.

The response to the above question involves the single, most important criteria for determining the success or failure of an income property investment. The brokers’ answer to the query indicates either extreme naivety or ruthless greed. Everyone is entitled to an opinion. Opinions come in many forms and play an important role in our society. However, when it comes to income property investing, math does the talking and is the basis for valued opinions. Good brokers know this.

Capitalization rates in the range of 3.5% to 5% are less than the rate lenders currently charge for mortgages on income properties. One of the crucial investment rules that applies to income property is to never invest with a negative spread, a cash-on-cash return lower than the mortgage rate. Why is this rule so important? Every penny borrowed on an income property with a negative spread is a guaranteed loss. Simply stated, if the capitalization rate is 3.5% and the rate to borrow is 5%, every $100 borrowed results in a $1.50 annual loss. Given this example of a 1.5% spread at 70% leverage, cash flow is terminated.

Why do income property investors need to leverage their investment? Income property is a single-revenue (rent), thinly margined, market driven, capital intensive, cyclical business with a fixed number of clients. To be yield competitive and attract capital, these characteristics dictate the need for income property investors to leverage.

Cash-on-cash returns for income properties with a negative spread are not as attractive when compared to income properties with positive spreads. Consequently, income properties with a negative spread attract less capital. Less capital translates into market value atrophy. Experienced investors and responsible asset managers (not influenced by brokers) know this, and will not invest in income properties with a negative spread.

Over the long-term, the affect of negative spread on income property is cancerous. Not only will the cash-on-cash return for the investors be lower, it also means less money for preventive maintenance, capital improvements and marketing. This is ruination for an income property investment. Income property with a negative spread is an investment in a non competitive cash-on-cash return with an overall return-on-investment that carries an unreasonable risk.