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Dennis Kwon
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Help a newbie! Cap rates: stabilized vs value add

Posted Nov 13 2021, 07:53

Hey all,

First time poster here! Just started to get my feet wet in the real estate space and I'm reading as much as I can to learn as quickly as I can. I'm interested in being a passive investor (I'm a young doctor who loves his job and has no interest in owning or managing properties at this time). Syndications/funds seem interesting, though I've never invested in real estate before and am brand new to the space.

With that being said, 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....

Price = NOI / cap rate

If I were buying a Class A stabilized property, I would imagine I (along with the entire real estate market) would be willing to pay a premium price to purchase this property so the cap rate would decrease. On the other hand, if there were a poorly managed property, given the same NOI, I would be willing to pay a much lower price so the market sentiment aka cap rate would go up.

Furthermore, there is this idea of cap rate compression where as you do renovations on properties, the price would go up and you would compress the cap rate. Does this mean if you were to buy a value-add property with an already low cap rate, the cap rate would go even further down? This seems weird to me. 

And why do people always say things like "I turned a 5 cap into an 8 cap property." What the heck does this even mean?

What am I missing here and what concepts am I misunderstanding?

Thanks for all your help!

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