Who in the World is Buying Class C Apartment Buildings at a 7% Cap Rate?

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Finding good apartment building deals is tough right now – almost anywhere in the country. I was curious to find out what kind of investor is actually buying these over-priced deals and so I polled my network of commercial real estate brokers.

When I say it’s tough to find good deals on apartment buildings, I’m not talking about the super-nice, Class A type properties, which normally command lower cap rates anyway. I’m talking about the Class C type properties in perhaps not-so-nice areas that have typically delivered higher returns.

Not any more. Now these properties, when stabilized, are commanding cap rates of 8% or even lower on both coasts, and not that much higher in the middle of the country.

What’s up with that?

I wanted to find out what kind of buyer is willing to overpay and put up with these rather paltry returns. I asked this question to my commercial real estate brokers, and they told me there were primarily 4 types of buyers right now willing to put up with lower returns, which is driving up prices.

Buyer # 1: Newbies

Ah yes, the newbie. Eager to do their first deal. Ignorance coupled with unbridled optimism. Lax underwriting. Well, you get the picture. They’re out there, and they’re overpaying. Don’t be that newbie.

Related: 7 Mistakes of the Newbie Apartment Building Investor

Buyer # 2: Buyers with their Own Money

There is a TON of cash on the sidelines as investors are still uncertain about the stock market. People like the reliability of commercial real estate, and that’s where many people with money are investing their capital.

If you’re syndicating deals (like me) and you need to find deals to achieve acceptable returns for your investors AND leave some left over for you, competing with people that DON’T have investors is tough. Where YOU might need a deal with a 10% cash on cash return so that your investors get 8% and you get 2%, the investor who is using his own cash might just need a plain old 8% return and can therefore afford to pay more than you.

Related: Don’t Make This Mistake and Leave Money on the Table When Syndicating Deals

Buyer # 3: Foreign Buyers

There appears to be a lot of foreign money chasing U.S. deals. Some of it is coming from countries where wealthy individuals are concerned about the country’s stability and are looking to simply preserve capital. For them, getting a 4-5% return in return for stability is a good deal.

Buyer # 4: Buyers with Related Business

The fourth buyer is one that has a business that is related to the underlying real estate. For example, commercial construction or property management companies are able to make money from their related business as well as the real estate. That combination allows them to pay a little extra for the real estate if they can make up the difference with their property management or construction companies.

Conclusion

While I normally try to answer the question “So What? How does this affect my life and what can I learn from all this?”, I don’t have a good “lesson learned”. I just wanted to share with you my findings to the question “What kind of &%#@! buyer is willing to pay that much for this building?” In case you, too, were curious, now you know -;)

OK, OK … I can’t resist, maybe a few lessons learned:

  1. Continue looking for that good deal. Stay persistent. Grow your network, talk to more brokers or send more letters. Consider investing out of your own area.
  2. Don’t relax your underwriting requirements and talk your way into a deal.
  3. Be patient. It might take a while to get that next deal, that’s OK.

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About Author

Michael Blank’s passion is being an entrepreneur and helping others become (better) entrepreneurs. His focus is buying apartment buildings by raising money from private individuals. He’s been investing in residential and multifamily real estate since 2005. He is the creator of the Syndicated Deal Analyzer and the eBook "The Secret to Raising Money to Buy Your First Apartment Building".

35 Comments

  1. Engelo Rumora

    Thanks Michael,

    There is some crazy buying happening out there.

    As you mentioned 4-5% cap rates are decent returns compared to the figures some foreign investors receive if they invest in the country of their origin. Many get caught up in the “paper” figures and never have any understanding of the reality and what it takes to make the numbers work.

    Personally I would suggest that any investor looking at buying C or D class should not go higher than a duplex maybe a triplex. Unless they can have a property manager in place that has 3-5 full time staff and they pound the doors of no more than 200 units.

    Thanks and have a great day.

  2. Hi Mike, I’m a bit shocked you’d syndicate a deal that offers only 10% native cash on cash!! That offers NO room for “oops” events and reality not panning out.

    What happened to MF investors having 20% COC as the minimum line in the sand? Mine is 25% but I don’t look at MF anymore because of the low returns and high barrier to entry at the 100 door level.

    • Michael Blank

      Hi Curt … the 10% Cash on Cash return was only an example … my criteria, too, is higher than that, and tough to find! I think it’s back to what it was like finding deals in 2005 and 2006, send out letters and hustle!

  3. If it wasn’t for newbies, the ‘old timers’ would have to sit on our property forever. Any sale you can get with a sub-8% cap rate on a class C property is a great one. If buying, I want much better…

    Let the newbies buy now, as they did in 2002-2006, and we can clean up in a few years.

  4. I am a newbie and this article is very discouraging. I see 8% cap deals on C properties in my area every now and then but there is always something about the numbers that does not support even that 8%. Expenses are lower than 50% of gross, occupancy is projected to be 100%, rents magically rise every year, etc.
    Once I start doing my own analysis using last 12 months actual numbers I usually arrive to the price being 20-50% less than asking. Then I walk away.

    So, my $1M question is this:
    Does it make sense to buy anything right now to “get my feet wet” or;
    Wait for the next recession (2016-2017) and buy then at a more realistic price?

    • Nick, you should ignore the asking price! Calc your own valuation and your own needed cap rate and write the offer up. Never don’t offer if you like the property. Make offers, right?

      You’ll meet folks, create relationships and may find a pocket listing that hasn’t been spoiled by ridiculously high offers and you may get it. Or you’ll source your own MF a bit smaller without a broker that you offer on and get.

      • Michael,

        Every deal I come across looks like a good deal if I can get it at the right price. It’s just the price has to be sometimes ridiculously low.
        This is probably a silly question but what constitutes an offer? Is an email to a listing agent asking “will your client sell for $XXX” enough? I never go past that email.

        Thanks
        Nick

        • Michael Blank

          That’s an offer in my book! There’s lots of “offer” activity before you actually submit a Letter of Intent … if the seller won’t consider your offer verbally or in email there’s no sense in going to the next step. One piece of advice though: don’t trash a deal, keep the file around and check back with the seller or broker every once in a while. Sometimes time changes things -;)

        • I do the verbal thing just a tiny bit, but I get an LOI in as soon as possible.

          1) It builds your confidence. Sending the 10th LOI is a lot easier than sending the 1st.
          2) It lets the broker know you are serious
          3) and this one is really important, at least for me, it let’s the seller know the basic terms that you are going to be holding them to when it comes to the contract. There’s a lot of difference between a seller thinking: “I’ll sell it to them for X and write up everything else to suit me” and “I’ll sell it to them for X, and I know that they are planning to have an inspection, wanting to get a loan at specific terms, going to expect specific important pieces of documentation, want to ok new contracts, etc”. Them having the terms of my LOI in hand gives me more confidence that, once we make it past the LOI stage, that we’ll make it through contract.

  5. Jonathan Goldstein on

    Another type of buyer who may consider 8% Class C is a large buyer already owning portfolio properties in the area, can leverage labor and enjoys economy of scale. Some markets out there are still strong but you need to have the right management infrastructure to manage right. This is THE key to any real estate investment. Managing right is not you managing your own properties yourself but finding the right manager who knows what he is doing. This is so difficult that maybe I can write a book on this topic someday. Only on this topic – finding and setting up the right partnerships. Anything else in real estate investing is not as important as your manager….good luck. In any case, the worst that you can do is just do nothing!

  6. Geez Michael, A cap rate is NOT a return. It merely represents what the market is willing to pay for a NOI. I agree there can be a skewing of this by unsophisticated buyers that START with a cap rate instead of looking at the market cap rate comps. People like J Scott say they are looking for a 12 cap but they base it on the subjects NOI against the subjects purchase price. Now when they buy the market that is buying at 14% cap are wondering what the heck is that guy doing overpaying for that property. But one sale does not make a market but if enough “investors” make this poor decision then it does become the market.
    A smart investor will find the market cap rate comps (or at least figure ther is a lot of foolish money bidding) and make their offer based on the ratio of the subject properties’ NOI against MARKET CAP RATE COMPS.

  7. Oh, and to answer your question directly. The people that are paying 8% caps for C properties are the ones that CAN’T afford the MORE profitable properties at 5% cap rates.

      • Nick Cap rates are set by market sales. Let’s say two buildings have a NOI (that’s the present income stream they’re both buying) of $50,000. If an investor buys that at an 8% cap they will be paying $625,000. If investors are paying $1,000,000 they are buying at a 5% cap rate. Since both investors are buying the same current $50,000 NOI you have to analyze why a sophisticated buyer would pay $375,000 MORE. Generally they either think the 8 cap area is not sustainable or that the 5 cap area will result in MORE value (profit) over time. And cap rate comps are not set by one buyer. They are the result of many market participants.

        • I know that cap rates are set by the market. They are what they are. That said, I still do not get why I (or anyone) would prefer 5% over 8%. Let’s take two hypothetical properties:
          one is class C with actual 8% cap rate (confirmed by actual P&L statements for the last 5 years) and another one is A class with 5% actual over last 5 years.
          Why would you choose 5% over 8%?

        • The market made the decision to pay more for the NOI. They thought it would be more profitable. The 5% and 8% are based on financials at ONE point in time and are not guaranteed.

  8. Too much competition, There is also REITS, big companies buying loads of buildings.

    I don’t pay too much attention to Cap Rate unless I don’t plan to renovate.
    When you are planning to renovation, the most important is the future Cash on Cash. Sometimes you can pick up a 0% cap rate building and make it a 8%+ cap months/years later

  9. We are in the process of selling a 20 unit at a 6.25 cap to a guy with a bunch of 1031 money. I can’t believe it but we are. My struggle is where to put my money next. We are looking at some office/warehouse units as the place to be but it’s really hard to find quality assets at good prices now. Makes me wonder if I just pay the taxes on this sale and wait.

    • Michael Blank

      Hi Michelle … as usual, it depends. For example, it depends on your investment criteria. Perhaps you’re looking for a certain amount of cash flow and you’re getting it, so why sell? Maybe you’re looking to pull cash out by selling or re-financing and you want to do it in the next few years. Commercial real estate moves in 5-10 year cycles from trough to trough, and we’re just beginning a seller’s market. Who knows how strong it’ll get and how long it lasts …

      • This is market dependent. We’ve been net sellers at this point with most of our stuff selling in the 6 cap range. In some markets, this would be a silly cap rate as there is little growth to justify that cap rate. With financing edging up (we are seeing rates in the low 5s), the cash flows off of these units won’t be much with cap rates in the mid 6s.

  10. Hi Michael, thanks for the article. This year I’ve been spending many hours trying to answer this question. I’ve been searching in Austin TX and I’ve seen offers, even from “big name brokers”, for C- properties, with C rents, in a C neighborhood for 5% to 6% Cap Rate; and somebody is buying them, insane!

  11. Hi Michael,
    Part of the reason we’re seeing ‘C’ properties sell for 7 caps, is that financing terms have really improved over the past six months. A year ago I would see bank financing at 75% LTV, 20yram, 5 year term.
    Now I’m looking at opportunities that involve Fannie Mae financing at 80% LTV, 30yram, 10 year term.
    Over a ten year period, the improved terms make a lot of sense – regardless of the cap rate.
    At today’s low interest rates – I received a 4.5% quote yesterday – locking in loan terms like these for 10 years can really improve the Cash on Cash return, as well as the annualized returns. And with the Fannie loan, the first year is interest only!
    Anyone who is sitting on the sidelines waiting for the next crash in commercial apartment investments is missing the boat. There is still a lot of money to be made right now, and Cap Rates are only part of the picture!

    • Brian, could you please share the name of the bank that offers 80% LTV and 10 years term? What size of a loan was it for and was it recourse or non-recourse?

      Thanks
      Nick

      • Hi Nick,
        The Fannie financing was offered through a commercial mortgage broker. I’ll be happy to share his info – once I get his permission to do so.
        A lot of the bigger commercial brokerage firms like Marcus & Millichap & Berkadia have financing arms as well, and they can help source all kinds of financing products.
        The financing I mentioned above was for a loan over $5million/non-recourse.
        In West Michigan I’ve been told that the Fannie terms will work for loans over $3mil.

        I’ve also heard of HUD financing at 80% LTV, 40 year am.

        It really helps to form relationships with mortgage brokers and bankers who can help you figure out the best type of financing for each investment. Right now I’m focusing on opportunities that are above the $3m range, because that’s where the best financing is available.

  12. Juan Maldonado on

    Hi Mike,

    I think you are forgetting #5. Big Value Add – Rehab Individuals. Take the example below of a property we purchased in the South Side of Pittsburgh, very desirable area of town due to university students and young professionals.

    Property was a three unit. Older building early 1920s (Typical for Pittsburgh), definitely c- condition. All 2 BDRMs 1 Bath. Purchase price $197,500. About 2 year ago

    Rental income:
    Unit 1 – $750
    Unit 2 – $500
    Unit 3 – $800
    Yr Income: $24,600

    Expenses (according to owner): $5,708 – Of course his expenses didn’t include: management/leasing, maintenance, cap ex reserve, snow removal. Not mention of vacancy or delinquency.
    Our expenses assuming increase in taxes and all else mentioned above on our pro forma was $17,326

    NOI at purchase (Our projected expenses) = $7,274
    Cap rate= $7,274 / $197,500 – 3.6% CAP

    1.5 Year later after putting $40,000 into property, updating the units & 1 leasing cycle.
    Units 1: $1,295
    Unit 2: $1,295
    Unit 3: $1,295
    Total Income: $46,620

    Expenses: $18,190 (not including Closing Costs or rehab)
    Cap rate= $28,430 / $247,500 (Rehab & Closing Cost) – 11.4% CAP

    In the end as Filipe and others mention. Cap rate is just a number. If you know your location, your area and most importantly your comps. Cap rates are not that important if you have a rehab – value add strategy.

    Recently our company opened a office in Austin, and I can tell you that if any broker was able to get find a listing on a C class asset in a C or better area and listed it at a TRUE 7 cap rate. The market will drive it down much lower. Same for San Antonio, or even Pittsburgh for that matter. For the value add / rehab player its not as much of where is the property now, more important questions are where is the market (Comps) and what is my cost to get this asset to market conditions.

  13. Nick, My name is Barry Lefkowitz from Meridiancapital.com , the market for financing is really hot right now were are closing 80% transaction all across the US. typical financing size is 3mil and up. rates are mid to low 4% for 10 year fixed , non recourse money!

    • Hi Barry, Thank you replying. I am a small fry: $750K would be a maximum for me to borrow at 80% LTV. Is this too small for your firm? — Nick

  14. I live in a US city of over 300,000 residents (Anchorage, AK) and bought two small Class C multifamily buildings here in early 2013.

    The eleven-plex was bought at an 8.5% Cap, the eight-plex at an 8 Cap. Fully professionally managed.

    They cash flow pretty well with 5.25% fixed interest rates, 20% down payments, and 30-year amortizations on 10-year balloons – an in-state program).

    Luckily, I locked in these rates right before Ben Bernanke uttered the word “taper” and interest rates shot nearly straight up after that.

    Arbitrage = Cap Rate – Interest Rate. That’s three points of arbitrage at purchase.

    Currently, what Michael writes about looks correct in my market. Investors have chased cap rates down and interest rates are up a little. This means that arbitrage gets squeezed from both sides.

    It should be noted that even with 7 Caps, it is still difficult to find a better investment than: leveraged, cash flow positive real estate in markets with job creation. Very nice column, Michael.

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