Commercial Real Estate

6 Advantages of Buying in an Expensive, Low Cap Rate Market

Expertise: Mortgages & Creative Financing, Personal Development, Landlording & Rental Properties, Personal Finance, Real Estate News & Commentary, Real Estate Deal Analysis & Advice, Real Estate Investing Basics, Business Management, Commercial Real Estate
175 Articles Written
cap rate

Those who know me well, know three things are true about me. One, I am not bashful. Two, I am good at what I do. Three, I like to teach—when I have the time.

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This said, the equity stack for our latest purchase is oversubscribed and I am able to relax for a couple of days. And, thus, while in transit to my niece's wedding, I wonder if I could offer you a few thoughts.

This will be short and to the point, but hopefully, you’ll get value!

The Advantages of Low Cap Rate Markets

The cap rates are compressed all across the country, as you know, which they have been. The unemployment is at historic low levels. The homeownership rate is basically back to historical norms. The millennials want to rent and so do the baby-boomers. The demand for a mid-range quality apartment product is profound.

When the interest rates increased about a year ago, the cap rates did not inflate. Now that the interest rates are coming down, the cap rates are not compressing meaningfully. It seems we've found a baseline where, relative to the fundamentals, the cap rates are "happy."

The cap rates have been low, are low, and my guess is that they will continue to stay here for a while.

There are those who complain about the low cap rates. Personally, I love it, and here’s why.

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1. Low Cap Rates Are Hard to Underwrite

Most investors don’t know how to underwrite low cap rates. Most are scared of low cap rates. This, as far as I can tell, creates an opportunity for me.

Related: Cap Rate: A Must-Have Number for Rental and Commercial Investors

2. Cap Rate Is Low for a Reason

The cap rate is a measure of market sentiment. The more people pay for the net operating income (NOI), the lower the resulting cap rate. By definition, a low cap rate is indicative of bullish sentiment.

What drives sentiment in investing? Safety and returns.

Question: Why would you want to invest anywhere but the low cap rate markets? Is it the safety that bothers you, or the returns? Because I am OK with both…

3. Equity (and Cash Flow)

You are probably saying to yourself right now, “What returns?! There is no cash flow in a 5 percent cap market.”

My response to that is twofold. First, people going to such a market don’t need cash flow. These folks already have more money than they know what to do with, and they are primarily looking for safety. They are the folks looking to pass their wealth onto the next generation.

Secondly, you are not one of them. So, you need to buy assets at 5 percent cap, which you can improve to a 7.5 percent cap, at which point two things happen. One is you can cash flow 7.5 percent cap just fine if you’d like. Or two, you can sell to one of the folks in the first category at a 5 percent cap, and make a rather impressive Delta, which brings me to my next point.

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4. Value-Add Is Easier in a Growth Market

Question: Is it easier to bump rents in a growing market, where the population and incomes are on the rise, or in a market where nothing is happening?

‘Nuff said.

5. CapEx Leverage

Improving the NOI by $100,000 in a 5 percent cap market capitalizes to a value of $2 million. Improving the NOI by the same $100,000 in a 10 percent cap market capitalizes to $1 million of value.

Now, I know I am old and my math ain’t 20/20 no more, but I think $2 million is better than $1 million—for the same effort.

6. More Buyers at the Exit

Buyers like safety and stable returns. I want buyers when I am ready to sell. The more the better.

Related: The Top 5 Creative Ways to Attract Cash Buyers for Your Properties

Wrapping Up

Low cap rates scare a lot of people away, which creates an opportunity for those of us who learn to capitalize on such an environment. It is, in fact, challenging to figure out the underwriting. But it is worthwhile.

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What’s your take on low cap rates and would you invest in this type of market?

Share with a comment below!

Ben has been investing in multifamily residential real estate for over a decade. An expert in creative financing, he has been a guest on numerous real estate-related podcasts, including the
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    Wenda Kennedy JD from Nikiski, Alaska
    Replied 12 months ago
    Yes, I agree -- IF you have the capital to go into that type of market. Yes, small LTVs and large equities are the goal of investing in my book. It creates a safety net that can take an investor a long way. It is a lot easier to raise rents in those markets due to upward pressures and/or improvements you can make along the way.
    Christopher Smith Investor from brentwood, california
    Replied 12 months ago
    I'm currently in a No Cap market, it was Low Cap from 2010 to 2013 when I bought in strong and I agree it's the thing to do for many of the same reasons that you mention. Will likely turn out to be the best thing I ever did, retirement that once looked problematic is now automatic (absent the 4 horseman of the apocalypse riding through my back yard).
    Ben Leybovich Rental Property Investor from Chandler/Lima, Arizona/OH
    Replied 12 months ago
    You've seen the code :)
    Danni Catambay
    Replied 12 months ago
    It seems to me like your analysis is specific to a certain type of investor. Those with a lot of capital to play with (be it cash, network or experience) and those interested in mid-size or larger multi-families in particular. On the other side, those who are just starting out are going to find these market conditions unforgiving. Personal capital is necessary to get started in this business and the smaller the cap rate in the market you're working in, the tighter the margins on cash flow. The less experience you have the less able you will be to add value either through NOI or forced appreciation. Put these two together and you conclude that a beginning investor undertakes massive risk in a low-cap market that a more experienced investor, or one who is able to move with larger quantities of capital input, will find significantly less troublesome.
    Ben Leybovich Rental Property Investor from Chandler/Lima, Arizona/OH
    Replied 12 months ago
    Danni, your analysis is spot-on. Such a market is not for newbies. The opposite side of the argument, though, goes like this: As they say, the tide raises all ships. However, as it relates to any market, Pareto's rule applies in that 20% of the participants are responsible for the tide, while the rest just ride the wave. Relative to RE, 20% of the markets are actually driving the growth on growth fundamentals, while most just benefit from riding the coattails. All I am suggesting is that it behooves investors to be in those markets that are responsible for the tide. Your response, on the other hand, is to say that because the barrier to entry is too high, most money should go into the lesser markets. Do you see the danger in your premise?
    Douglas Vogel Rental Property Investor from Washington
    Replied 9 months ago
    Ben, I really like this article. I do have one question though, if you have strong money partners, would you go into low cap rate markets even though you don't have the value or net worth to take it down on your own? I have a good network that has both liquidity and net worth but are looking for good deals, but I haven't done a "big deal" myself. I could take down a 20-30 unit with a partner or two in a 10% cap market or I could get an entire team together and take down a 30-50 unit in a 5% cap market. I'm assuming you would prefer the 5% market and increase NOI?