Cap Rates for Large Apartment Complex are Lower. Why?

Question

I am a new investor in New Haven, CT.  I notice the cap rate for large apartment buildings (50+ units) tend to price at much lower cap rates than smaller apartment buildings (4-10 units).  I'm referring to cap rates in the range of 5% to 5.5% for large apartment buildings vs 7.00% to 8% for small apartment buildings.  I am comparing buildings in the same neighborhood and in similar condition.  Any ideas why this is the case?

Michael Le · Answer

Others are saying demand but I would say that the more likely reason is that the smaller units are not accounting for all the proper expenses. Probably are self-managed by the owner and they are not accounting for their time and costs of management. And they're likely missing others too. And so it is artificially inflating the NOI and making the cap rates look higher. The larger properties are more likely to be professionally managed and thus the financials will be more accurate.

Charles Seaman · Answer

@Jerry Fung The reason for this is because larger apartment buildings have more demand from buyers.  The greater demand causes higher prices, which results in lower cap rates.

Thomas Higgins · Answer

@Jerry Fung - There is nuance to this question that some of the response you are getting overlook.

Cap Rates or your un-levered Yield you expect to receive from an asset is tied to the type of asset, its demand, and the market/submarket it is located in. It is also correlated to the Fed's lending rate, but there is typically a lag in this correlation as there are a lot of resources at the operator disposal to get attractive rates even as the fed rate increase (separate conversation)

Take, for example, a few different scenarios:

JLL brings to market a 180-unit property in Core+ Neighborhood with favorable politics, strong job, and population growth. The property is completely free market, a has very straightforward value-add program already approved by the city that will reliably increase base rents by 20% in the next two years, not including market rent growth. What cap rate will this sell for based on today's rent? Whoever buys this asset will underwrite it based on its stabilized cap rate after two years, not its current cap rate. This deal could trade at a 2% cap rate with in-place rents but a stabilized cap rate of 5.75%. With the correct leverage, even with today's rates, this asset could drive 12%+ IRR on a five-year hold, checking the box for many investors that want to put $10M+ in equity to work.

Let's take another example - it's 2017 in a Core market, and a local real estate company is selling a fully renovated duplex on Main and Main St with one unit vacant and one unit rented to a very high credit tenant. This property may be acquired at a 1-2% cap rate with no value add potential. A doctor wanted to take his money out of the stock market and buy something "safe" he doesn't need to worry about and maybe he will move into.

These examples are extreme but I am using them to illustrate that they is verity in size and asset type and the narrative that one is always lower or higher can be miss leading.

Another question to illustrate my point:

What would sell for a lower cap rate one newly renovated 150-unit building right outside of the downtown in a Core market or 20 newly renovated buildings containing a total of 150 units in the downtown. People will argue the 150-unit building, but by how much 25 bps? 50 bps? 100 bps? I would guess there will be less cap rate expansion than people think.

The best way to determine the market cap rate is to know your market and know your asset type:

• Speak with brokers that sell assets in the market you are looking at (add 25 - 50 bps to be safe).
• Start offering on properties and track what they sold for; update your model, and you will know.
• Speak with other investors that own or have purchased in that market
• Speak with passive investors or broker deals... what IRR or Cap Rate would they invest in or could they raise money for?

Happy hunting!

Nick B. · Answer

Cap rate is a measure of supply and demand. There is more demand for larger properties hence lower cap rates.

Samuel Eddinger · Answer

@Jerry Fung - I invest a lot in CT and New Haven has received a lot of institutional money from New York that goes back to Israel.  When you are putting money in play, it is a lot easier and better to put it into bigger projects (and buildings) than smaller.  It is all about cash utilization at that level.  If you can get double the CAP rate for a property but can only get 1/4 of your money in play on that property, your effective rate of return is actually 1/2 of the bigger property (for example).

While some of the other answers are also correct, I believe that the cash utilization and getting money into markets and investment vehicles efficiently is the major reason why CAP rates are lower than the 3 or 4 units.

I'm actually looking to start buying bigger buildings.  There are a lot of efficiencies as well with respect to common area maintenance that becomes extremely cost effective the bigger building you get (think landscaping, snow plowing and the ability to hire onsite maintenance personnel and property managers).

Jon Q. · Answer

Because large 60+ unit complexes often generate sufficient cash flow for you to high professional management.  Anything below 60 units will be a management hassle, though there can be ways to addressing it, with these smaller MF's the owners typically have to live onsite (sucks, don't do it).

Jon Q. · Answer

Yes, and demand is higher because of their ability to generate sufficient cash to hire a professional property management company.  But also cap rates vary based on location and because no location is the same, MF's will vary on cap rate (and buyers and sellers will argue cap rate differences in order to obtain a better deal).

Chris Seveney · Answer

@Jerry Fung

More demand and less risk on larger stabilized buildings than those smaller MF deals.

Sam Yin · Answer

@Jerry Fung

Take a moment to picture it. Larger complexes can raise their cap rates much more easier than smaller ones. It's a numbers game. The more units, the more profits with the same or less work as smaller apartments.

If you raise 60 units by $100, how much more did the NOI just grew vs raising 10 units by $100? That's a difference of $72000 vs $12000.

Therefore, after you verify the accuracy or the sellers t12 and rent rolls... at the end of the day, CAP rates relate to desirability of the product.

Bobby Larsen · Answer

I’m not sure if that’s true for the 4-10 unit space compared to the 50+ units after you correctly account for the higher expense load on 4-10 units. It is true for 50-125 units versus 125 to 500 units because the cost of equity is lower (at least as of today). Large institutional

investors are flush with cash and they can put larger check sizes to work with the same level of work.

Cap Rates for Large Apartment Complex are Lower. Why?

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