A lower Cap, but higher appreciation potential or vice versa?

Question

Hi All,

I'm extending offers for two, 2-unit properties as "buy and holds" with a lot of upsides, but unfortunately I can't have both so I have favored price-points identified. They are both A properties, but one has a ~10% Cap rate w/ a lower appreciation potential and the other is a ~8% Cap w/ a much higher appreciation potential. To compound the issue, the ~8% Cap rate has current long-term renters, but the ~10% Cap rate has one long-term renter and the other unit was previously owner occupied so my calculations are based on a very conservative average of comps. Both are in great areas as indicated by the "A", but the ~8% Cap property has the most traffic and comparably highest caliber of tenants.

My question is:

Is the higher Cap rate w/ lower appreciation potential favorable for a long-term purchase (>10 years) or is the lower Cap w/ the higher appreciation potential and current occupancy a better bet?

My portfolio and strategy are buy-hold income generators and there is no foreseeable scenario where I would have to sell within 10 years.

I welcome input from the BP community.

Stephen Franco · Answer

I go for 15-21% cap rates in Scranton / WB pa (after maintenance/vacancy/management) over appreciation.  PM me for info

Bill Gulley · Answer

Sorry it took so long;

You're right, but I'm not speaking about "the market" I'm addressing one property. You're right that it is similar to price equilibrium.

If I raise the cap rate, (in my purchase analysis today) the present value of my income will be lower. After I purchase, over time, forced appreciation may increase my cap rate and I can expect a higher future value for a better performing property, all things being equal.

Because things are never equal, I never really consider a seller's claim of their cap rate because their's will never/rarely be the same as mine.

Cash on cash is a much better analysis, IMO. :)

Account Closed · Answer

Did you misspeak?  Generally a low cap rate market is because of anticipation of increasing rents and appreciation where high cap rates reflect little change in either rents of value.

Bill Gulley · Answer

Higher cap rates support higher expected appreciation. If you have a low cap rate and expected appreciation is higher than the rents support, your rent is to low or expenses are too high or you have external market factors (area, neighbors, external obsolescence) depressing rents and therefore appreciation.

While you may think your expected cash flow is conservative, I'd take another look at the prior owner occupied unit, it is probably in better condition requiring less maintenance in the near future, an assumption, rarely are different units apples to apples in reality.

Oh, yes, I prefer appreciation which supports higher future rents. As long as the cow doesn't eat the hay, you'll make more selling the cow later than the milk. :)

Russell Brazil · Answer

There really is not much difference between the 8 and 10% cap rates. A few things here and there and the properties might swap cap rates. So with that in mind, Id take the one with the better chance of appreciation and the slightly lower cap rate.

Thomas S. · Answer

You decision should be based on your ability to afford the different scenarios. As rents go up cap rates change over time. Expenses vary with time as well so really all you are looking at is estimates that are valid today. Also keep in mind appreciation is pure speculation that may not pay off.

I would also not place any value on the tenants only the rent. Long term tenants today mean nothing if they decide to leave tomorrow. They add no value to the property, vacancy costs are built into the expenses and are simply part of the business.

My personal preference would be the higher initial cap rate.

Derek Lamonde · Answer

Thanks and I'm leaning the same way for a couple of other reasons, e.g. long term tenants and established history, etc. So let me ask one more:

The ~10 Cap property bid is highly likely to be accepted.

The ~8% bid is probably a bit low and I'm thinking the final landing price would push the Cap closer to 7%.

So would you still prefer the appreciation prospect at the difference between 7 and 10% Cap rates even over a long term hold period?

Carrie Hiner · Answer

The cash flow difference between 8% and 10% percent is minimal... I like long term capital growth.  Best of luck.