Had a quick conversation with a loan broker last night about the loans available on 5+ unit apartment buildings right now.
You can now get a 5 year fixed, non-recourse bank loan for 3.62% interest.
Let’s take a look at what that means by using the example of a 5% cap deal, which is a pretty expensive deal for all but the most desirable parts of LA:
- Price of $1MM
- Downpayment of 25% or $250k
- Borrow $750k
- Net operating income of $50k (5% of $1MM)
- Annual debt service of $41k
- Free cashflow of $50k – $41k = $9k
You’re only earning $9k in cash against your $250k downpayment, which is a cash-on-cash return of $9k / $250k = 3.6%. Not great. But that doesn’t consider the amortization of the loan.
By making the monthly payments for 12 months on a $750k loan at 3.62%, you reduce the principal (what you owe the bank) by roughly $12k. To fairly calculate your return, you do need to consider the effect of this principal pay-down, particularly if you plan to hold the building for a while.
If you add the $9k cash plus the $12k principal paydown, you’re looking at a return of $21k on your $250k downpayment, or 8.4% in year one. And, as we’ve discussed before, because of the way that loans work, the amount of principal you retire increases every year (basically, more and more of your fixed monthly payment goes to pay down the debt rather than pay interest on it). So the total return gets better every year.
Am I advocating that everyone rush out and buy 5% caps with lots of cheap leverage? Definitely not. I don’t think the deal above provides enough of a margin of safety for most investors.
But the numbers above do help explain why the market for apartment buildings is so hot right now. With debt that cheap, even bad deals start looking pretty good.