Nashville Capitalization Rates
"Nashville Capitalization Rates"
by Casey Richards
I've been curious for some time about what factors go into determining the market cap rate for investment properties here in Nashville. When I first arrived in the city back in 2004 it wasn't at all unusual to see cap rates above 10%, but recently the rates have started to creep downward. Today rates on a duplex in the metro area will range from 7-9%. However, if you were to pack your bags and head just a few hours West, you could still achieve those double digit cap rates in Memphis. This lead me to dig deeper to figure out what factors drive the prevailing cap rate here in Nashville and across the country.
My research lead to me something called the derived cap rate. It ends up that you can dissect the cap rate using this approach which splits it into two parts. The two primary factors are financing and equity.
Most investment properties are purchased using a mortgage in order to maximize leverage. The mortgage company is going to be getting a return on their money which makes up the financing portion of the cap rate. You must isolate their profit if you wish to determine your profit. Since the return to the lender is fixed, the remaining return on equity goes to the investor which also makes up the remaining portion of the cap rate. Let's take a look at an example.
The typical investment property will be purchased using an 80% mortgage with a 20% down payment. According to the Wall Street Journal, the average interest rate charged by lenders for a 30 year fixed rate loan is currently at 4.68%. We will round this number up to 5% since you probably won't get the best rates on any investment property..
The first step in determining the derived capitalization rate is for you to examine the financing component. You start by looking up the mortgage constant for your expected loan (Mortgage constants can easily be found online through charts such as this one: http://www.boe.ca.gov/info/tvm/lesson8.html). If you lookup the constant for a 30 year fixed loan at 5% you will get 0.0053682. This mortgage constant is equal to the monthly payment amount you can expect per $1 of mortgage balance. Since you will be dealing with annual cap rates, you will need to multiply this constant by 12 to get an annual payment.
You now have the mortgage companies cap rate. Since they are providing 80% of the funds required for the purchase, you will need to multiply by .80 to get their portion of the final derived cap rate. Thus far the process should look like this:
Monthly Constant (0.0053682) X 12 Months = Annual Constant (0.0644184)
Annual Constant (0.0644184) X 80% LTV Mortgage = Financing Cap Rate (0.0515347)
Next, we will move onto the investor's portion of the calculation. An investor will start by looking at the safest investments that are available in the market. Right now that might be a 10 year Treasury bill. Currently the rates on these bills is 2.96%. As an investor this rate represents what you can safely achieve with no effort or headaches. You will never get a phone call in the middle of the night saying that your Treasury bill is on fire or that it's pipes burst. The money invested here is 100% safe and the return of your investment is guaranteed.
In order to move your money from this ultra-safe investment to the more risky Nashville Real Estate Market, you are going to require a much stronger return to compensate for the much larger risk, but how much is enough?
This part is subject and each investor will have a different minimum return based on their own risk tolerances and the specific risks for the individual investment property. Let's assume if you can get 3% from T-bills and 8% from the stock market, that you would require at least that much to invest in real estate. Using 8% as our minimum number you can now calculate the minimum derived cap rate for an investment:
Annual Constant (8%) X Down Payment (20%) = Equity Cap Rate (0.016)
Finally you add the financing cap rate to the equity cap rate to get your derived cap rate:
Financing Cap Rate (0.515347) X Equity Cap Rate (0.016) = Derived Cap Rate (6.75%)
As you can see, our personal minimum cap rate for an investment in Nashville (to achieve an 8% return) is 6.75%. That is right around the current market average of 7%. Since Nashville has achieve such outstanding appreciation and rent increases over the last several years, investors are willing to receive a smaller return in Nashville than in cities like Memphis or Knoxville which will require a larger return because the outsized appreciation in those cities is less likely.
Which brings us to the question of why bother with all this math? We could just accept the market rate as adequate to provide a return equal to the risk. In most cases this would be true, but when comparing markets it helps to understand how to examine derived cap rates in order to determine the actual cash-on-cash returns that investors are achieving in those markets.
Using a Nashville Metro Area Duplex with an 8% cap rate, 30 years fixed mortgage at 5%, and a 20% down payment as our example, we can work backwards using this process to determine that this property should return 14% cash-on-cash in the first year of ownership. Not bad!
A final use for derived cap rates is that it can help smaller investors to realize the best use of their cash at a glance, when cap rates drop below 6.5% you can probably do better in the stock market which is something worth considering.
May 6th, 2018
The math used to determine the cash-on-cash return for the above example:
Market Cap Rate (8%) - Financing Cap Rate (0.0515347) = Equity Cap Rate (0.02847)
Down Payment (20%) / Equity Cap Rate (0.02847) = Annual Constant (0.14235)
Annual Constant X 100 = Cash-on-Cash Return (14.24%)