Sacramento Cap Rates

13 Replies

Hi everyone,

I’m considering investing in Sacramento and I wanted to see what cap rates investors are experiencing on Class B small commercial apartment buildings (5-10 units). I know there has been quite a bit of cap rate compression over the last 12 months, so I’d love to hear from anyone who has recently purchased a property to see what they getting. If you could specify the general area in which you invest that would be great.

Thanks!

I just represented a buyer in Sacramento on a 8 unit property. He will be getting 5% cap rate but the rents are low and he will be increasing rents to get the rate to 6%. The best thing about it is that he obtained 1.67% seller financing though.

Originally posted by @Kyle Murphy :

Hi everyone,

I’m considering investing in Sacramento and I wanted to see what cap rates investors are experiencing on Class B small commercial apartment buildings (5-10 units). I know there has been quite a bit of cap rate compression over the last 12 months, so I’d love to hear from anyone who has recently purchased a property to see what they getting. If you could specify the general area in which you invest that would be great.

Thanks!

Hi Kyle

Looking at the cap rate is a good first step but you always have to look at the 'whole' and the CR is just a part.  The Sac market is an active one and you have to get inside each deal.  5% cap rates are low but as Gordon noted, not to be ignored.  If rents are under market, the asset is in good condition (little CapX to worry about) you mignt actually be looking at a 6 or 7 cap rate, maybe even better.  The flip side is also true as in be careful.  I represented a buyer just recently on a 4 unit med office with about a ten cap.  But after getting inside and estimating that there was going to be a lot of expensive rehab work to be done, the buyer figured that 10 was really a 2 after the work he would have to put into it.   At face value it looked good but a closer analysis told a different story.  It is an active market up here with a lot going on.

@Gordon Cuffe Thanks for your reply. That sounds like a great investment! Seller financing at a fixed 1.67%?? In this low interest rate market (although on the rise), and with the stock market under performing, have you seen an incrase in sellers willing to finance the sale?

How does a seller justify < 2% interest earned as a good allocation of their capital? I was under the impression that most seller financing rates were at or above your typical commerical loan rate (4-5%).

@Brian Serina Brian thanks for your response. Deferred maintenance and below market rents, among other things can abosolutely distort cap rates. Have you seen any best practices for estimating capex for a building?

Brian, based on your response and @Gordon Cuffe 's response, it sounds like I should be shooting for a pro forma cap rate of ~6-7%. I would assume that most properties advertising 8-10% cap rates are not Class B buildings/tenants (maybe C/D) and are likely the type of properties to have more deferred maintenance. Would you agree?

Don't forget that CR = NOI / purchase price and when one uses OPM via a loan, CR doesn't matter a bit, and the cash-on-cash = NOI / down payment is a better metric for the use of your money.

NA Beard I'm assuming OPM = Other People's Money?

I'm not sure I understand. From my understanding, Cash-on-Cash return = Cash Flow / Down Payment. The Cash Flow takes into account P&I which means that the interest rate on the financing does come into play when looking at cash-on-cash return. Are we saying the same thing? Does anyone disagree?

Originally posted by NA Beard:

Don't forget that CR = NOI / purchase price and when one uses OPM via a loan, CR doesn't matter a bit, and the cash-on-cash = NOI / down payment is a better metric for the use of your money.

Agreed that Cash on Cash ("COC") is a better metric in assessing your investment. Question for NA Beard - what is the best way to approach COC returns when one takes out an ARM on a commercial multi-residential property? I know what my COC is on day 1 and I can reasonably forecast COC (during the fixed time of my ARM) down the line by making rent increase assumptions - but if my mortgage adjusts in, say, 5 years, how do I pro forma my COC return? Do you simply assume worst case scenario (i.e. if rate adjustment cannon exceed more than 1% per annum, do you simply assume a 1% rate hike each year from year 6 onward)?

@Peter Aziz   


The problem is MFUs commercial loans are always ARMs and it's hard to plot C/C when you buy&hold long term (I'm now into my 18yr). There's a mathematical approach but it's complicated statistics. I see two possible approaches and your plan to keep or at what point to exit the property.

It is common for many to exit a property in the 7th year, as when sold, the depreciation recovery beyond that point eats the profits of the sale. If however, your plan has been to buy&hold for the c/c return, the sale is important but not where you made your money.


The key to ARMs is the terms (isn't that always the case).

I'll play with one example:

  1. Terms of 3% due in 5, for 20yrs, annual cap of 1%, 5% lifetime.


So each year (assuming increasing constant cost of funds at the full rate each year; which is worst case analysis), your rate increases 1% (3,4,5,6,7,8 {the 5th year} ) and the question is "what happens to the C/C each year?"
(whole integer increase every year is unlikely but illustrative of the analysis)


First, by the example cited, the 5th year also becomes the max rate, so if we hold that long, we will know the highest rate forever. So, calc the impact of the impact of a 8% rate; is it tollerable and would we elect to be satisfied with this C/C?


If not, rerun the numbers in reverse (7,6,5,4) and find the C/C for each and you can then pick the year in which you would elect to exit.

Thanks for the illustration, NA Beard. The only downside I see with this approach is the potential to be upside down on the sale assuming your illustration holds true (however unlikely it may be). Let me explain:

Let's assume you acquire a $100K building today at a 5% CR. A 5% CR works when rates are 3%. 

Now, let's assume that by year 5 interest rates are at the illustrated 8%. Investors will require much higher CRs. Assume that investors will now require a 10%CR, now you're sitting on a building with a FMV of only $50K (assuming rents/expenses did not increase, which again is unlikely). If you put 20-25% into this deal at acquisition, you wouldn't be in a position to sell at a profit - the inverse holds true - you'd sell at a loss. Am I missing something?

@Peter Aziz

  1. Let's assume you acquire a $100K building today at a 5% CR. 
  2. ...
  3. now you're sitting on a building with a FMV of only $50K

in a declining market you've got lots of issues and hopefully, the investor is tracking FMV all the while.

We all know there was a balloon in '08 and FMV took a dive. But RE is cyclic and it waxes and wanes ~7-8 years. Even in the Great Depression of 1928, the stock market recovered in ~18 months. Those with guts just waited it out and collected cheap investments in the meanwhile.

If you buy&hold, you pick your moment to sell when it's advantageous to you.  Any cyclic behavior becomes irrelevant.  If you're skittish, panic and have a fire sale, you loose.  There are cases when the investor is 'forced' to sell and no one can predict those sad events.

@Kyle Murphy Brian is correct on what cap rates to shoot for. This seller financing is not typical. The buyer was a savy investor who came up with the idea and it was good for the seller as he was trying to defer capital gains taxes. I can go into more depth if you ever want to via emails. It seems that there are many bay area buyers coming to Sacramento to buy just because the cap rates around the bay area are lower.

Originally posted by @Kyle Murphy :

@Brian Serina Brian thanks for your response. Deferred maintenance and below market rents, among other things can abosolutely distort cap rates. Have you seen any best practices for estimating capex for a building?     

We always first start out with our own analysis. Get out and take a look, a real close one.   Look at the roof from a distance.  Use your broket, get his opinion.  If the owner's broker is there, ask him.  Pay attention to their responses.   We went out to a 14 unit MF and with binoculars from across the street you could tell it was in bad shape.   I told the client to save his money on getting a roof inspection done.  Rather, call a roofing company and ask them cost to completely replace, not repair, the roof, and budget for it.  And use their high number.   If the a/c units seem old, you will be replacing them, for sure.  Go to costco and see what a unit costs.  In our situation we called a licensed handyman his cost to switch out and install 14 of them.

And if your offer is accepted, get a property condition assessment so you can fine tune your costs.   Many units had water stains around the tubs and sinks.  Call your gc and ask him cost to gut and completely redo a bathroom X 14.  Note, we were shown a couple of cleaned up vacant units, i think they were more like models to get us to think all of the other ones were like those.  Clearly they were not.