In the world of real estate, it is common to hear claims that seemingly abnormal market conditions are normal. Some brokers are classifying the current capital gains range of 3.5% – 5.5% as commonplace where in reality this is something that should be carefully considered when contemplating the purchase of income property. What seems acceptable in today’s market can in fact be a long term disaster.
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 broker’s 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.
Leverage enables an initial investment to be spread out over multiple properties, taking a minute profit and making it a bit more palatable. It also spreads out risk –as the saying goes “don’t keep all your eggs in one basket”.
Overall, the model that emulates a negative spread is not sustainable. Because return on investment is minimal, the investor will not be able to provide basic necessities such as repairs, improvements, or rental advertisement. Ultimately, the risk is much greater than the potential for reward.