Summary of Results

Let’s review the results of a real estate purchase at a 5% cap rate with the economic occupancy declining from 95% at close of escrow to 80%. Is an 80% economic occupancy unrealistic? It’s as unrealistic as 88.33% physical occupancy plus a one-month rent concession. Put in those terms, 80% economic occupancy is very realistic. Additionally, a 35% down payment is conservative. There is no allowance for reserves which in this case would be $20,000 (usually 2% of the purchase price). Finally, when economic vacancy increases, operating expenses don’t remain the same, they increase. Now let’s look at the financial results at 80% economic occupancy.

• The cash investment (down payment) declined 70.3%.
• The property is not earning enough to pay operating expenses (negative NOI).
• The property is not earning enough to pay debt service (negative cash flow).
• The property is not earning enough to fund reserves.
• There is no consideration for the financial terms (income guarantees, warranties, seller financing, etc.) the next buyer would probably negotiate.
• There is no consideration for the costs of a sale.

Conclusion: When income property is purchased at a 5% cap rate, what we have at 80% economic occupancy is a failing business.

What would have happened if our real estate investor bought the same property at a 7% cap rate? Using the assumptions from the prior example, here’s what happens with a purchase of the same real estate at a 7% cap rate.

Table #2 illustrates the significant financial advantages between acquiring income property at a 7% cap versus a 5% cap rate during a weak market (economic truth number one).

Assumptions

• Purchase price: $714,286
• Economic occupancy on purchase: 95%
• Cap rate: 7%
• Down payment: 35% ($250,000)
• Mortgage: 30 year amortization, interest rate 6% + normal closing costs
• Operating Expenses: same as 5% cap rate purchase
• Economic vacancy: declines each year by 5%

Summary of Results

The point of these two illustrations is to demonstrate the significant financial differences between buying the same real estate at a 5% cap rate versus a 7% cap rate.

The 7% cap rate pays operating expenses, funds the reserve account, and pays the investor a positive yield. The 5% cap rate does not have funds for operating expenses or the reserve account, and does not pay the investor a yield. That means the 5% cap rate does not have enough cash available to maintain the property as planned and compete against properties purchased at a 7% cap rate.

Conclusion

Another way of saying the risks are greater than the rewards is that the investment lacks staying power. How important is staying power? Consider our two earlier facts. (1) Real estate is cyclical, and (2) whatever percentage an investment declines, it must increase by a higher percentage to achieve parity. Given those two factors, staying power (a 7% cap rate) becomes the real estate buyer’s insurance policy for achieving investment success. The conclusion: For real estate buyers, a 5% cap rate is the breaking point when the risks become greater than the rewards with the probable result of the income property purchased committing hara-kiri.

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