I recently came across a single tenant net-lease deal with an extremely aggressive cap rate. As I reviewed the metrics, I asked myself, “Why would anybody buy that? You are probably better off buying Treasury Bonds…” Then I thought, perhaps with leverage the annual returns could become a little more respectable, but I was wrong, this cap rate came in well below the line of positive leverage.
Even with today’s historically low interest rates, it is still possible to have negative leverage. This prompted me to determine the “break-even cap rate for leveraged returns” based on a set of interest rates and loan terms. Break-even cap would be the breaking point between positive and negative leverage. In other words, the cap rate must equal the leveraged cash-on-cash returns. For the purpose of my analysis, all calculations were ran assuming a 70% LTV. Here are the results:
I expected the trend line to have somewhat of a exponential curve, but to my surprise, the relationship between interest rates and break-even leveraged cap is actually very linear. Further, the slope of the trend lines between 15, 20 and 25 year amortization scenarios are very similar. Also to my surprise, altering the LTV ratio had very little effect on the trend line. I ran a simple linear regression analysis on the results and came up with a simple formula for finding the break-even leveraged cap. The variables in the formula were based on the trend line, therefore the results will not be exact, but it should be within a few basis points.
In hopes to even further simplify this process, I came across an equation in an old college text book:
Target Cap Rate = (N x LTV) + (R x (1-LTV))
Where N= Mortgage Constant, and R= Desired Rate of Return
The purpose of this formula is to compute a target cap rate based on a desired leveraged return. After an Algebra refresher from my dad, I simplified this formula and came up with the following:
Break-even Cap = Mortgage Constant
I was shocked at first. I had somewhat of a “Eureka!” moment, until I started thinking about it logically. The mortgage constant is a measure of annual payment as a percentage of total loan value. By making annual payments as a percentage equal to the return on the property, your debt is essentially paying for itself, and the equity portion provides the same return as it would in an all cash purchase, there are great purchases at cbdoilkaufen.
It is important to note that I used before-tax cash flows for the purposes of my analysis, and there were no closing costs or other fees included in the calculations. Regardless, I believe this helps to illustrate how increasing interest rates will affect market cap rates. At the very least, hopefully my discovery can be used as an evaluation tool next time you consider leveraging an asset that provides long-term stable cash flows like a single-tenant net lease asset.