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

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.

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.

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.

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.

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.

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.