Originally posted by @Dennis Kwon:
I'm reading through Brian Burke's book - The Hand's Off Investor. In the section discussing Cap Rates, I'm having trouble wrapping my head around why this statement is true: "Cap rates on stabilized properties tend to be higher than cap rates on properties that require value-add"
My internet search and search through BP forums leads me to believe that stabilized properties should have lower cap rates....
The disconnect here is you are attempting to compare apples to oranges: cap rates for a "value add" versus "class A." This is kind of like saying "which is faster, an airplane or an aircraft." An airplane is an aircraft, but an aircraft doesn't have to be an airplane, it could be a helicopter, glider, or balloon, too. Same goes here. A "class A" could be a value add. Or not. And a value add could be a class A. Or not.
Instead, let's compare like for like:
Deal #1: A class A that is fully stabilized and rents are roughly equivalent to the comps (meaning there's no value-add potential here), versus
Deal #2: a class A that isn't as well amenitized as it's peers, the management is disorganized and hasn't kept up with rent increases, the interiors, while nice and certainly up to class A standards, lack some basics like stainless steel appliances (it has white) and a nice tile backsplash in the kitchen.
Clearly they are both class A, and clearly deal #1 is NOT a value add. Deal #2 is a value add--by changing out the appliances, adding a tile backsplash, improving the gym, adding a dog park, upgrading the signage, and putting professional management in place that has its eye on the ball, the new ownership can achieve significantly higher rents than the property is currently getting. No higher than deal #1, but equal to it.
Now let's examine the purchase. Deal #1 has NOI of $1,000,000 and is selling at a 4% cap rate, so a price of $25 million. Deal #2 has NOI of $750,000 and is selling at a 3.5% cap rate, so we'll call that $21.5 million. YES...see here that the value add deal is a LOWER cap rate?! Now, let's work beyond the purchase to see why.
Deal #1's year 2 NOI is still $1,000,000 because rents were at top of market and there was really nowhere else to go. Deal #2's year 2 NOI is $1,000,000 because the new owner made the improvements and changes listed above (we're talking theory here, it probably takes 2-3 years to do this but doesn't change the logic behind the concept). Let's say it cost them $1 million to do all of that.
Now let's examine where both owners are. Deal #1 has $1M of income for $25M, giving a yield on cost of 4% (for simplicity I'm not adding in closing and financing costs because they'll be roughly the same for both and overcomplicates an already complicated discussion). Deal #2 has $1M of income for $22.5M ($21.5M purchase plus $1M improvements) for a yield on cost of 4.44%. So who came out on top? Yes, deal #2, despite paying a lower cap rate for a value-add property. Same income, lower basis, and higher yield on cost, despite lower cap rate.
The answer to why value add trades at a lower cap rate than stabilized deals is because buyers are willing to pay a premium for an income stream that they can grow.
You aren't compressing the cap rate as you renovate. Instead, you are growing the income. Another mistake here is that people incorrectly think they control the cap rate. They do not...cap rate is a measure of market sentiment only. I always assume that when I buy a value-add deal the cap rate would go UP. Take the examples above. If you were to sell both deal #1 and deal #2 above, deal #1 sells at a 4% cap rate (we're assuming the overall market sentiment hasn't changed since you bought the property), and gets a $25M price. Deal #2 also sells at a 4% cap rate (because that's what the market cap rate happens to be for stabilized assets and now that you fixed up deal #2 it's now a stabilized property). You bought deal #2 at a 3.5% cap rate, so the cap rate went UP by 0.5%. BUT, on deal #1 you lost money after selling for the same price you paid (then paid commissions, etc), but on deal #2 you made money because you are in it for $22.5M and are selling for $25M. So forget about "moving" cap rates, and just focus on moving the income.
People say this when they don't know what they're talking about. Read this article, it'll clear this up plus the other incorrect information you commonly read (even in these forums) about cap rate. https://www.biggerpockets.com/... If you're really a glutton for punishment and want to dive even further into cap rate, check this one out too. https://www.biggerpockets.com/...