What are the pros and cons regarding high cap rates?
Downey, CA · Member since 2014 · 20 posts · 7 votes
I have recently read a post that mentioned high cap rates can be risky?
I am new to investing and up until the other day, I believed that the higher the cap, the better the income. What are the pros and cons of this? I am leaning towards obtaining some MFRs and I want to be sure Im doing my research right.
Whenever you see a high CAP you must ask yourself - why? There's always a reason, and most of the time it's not good :)
When you read Pro Forma, which presents you with a chain of logical information resulting in a CAP rate, it's important to remember that the rate is only as good as the information, and the information is nothing more than someone's spin...
Case and point - I put in an offer today on 100+ units. The asking CAP was at 9.5 - having done the research and using real numbers, it bacame clear that the true rate had I paid the asking price would have been 3.3%...
My offer reflected this lol
@Account Closed the 50% is usually used for the first look on rental units of 4 or less. I do not recall anyone using the 50% rule for larger multi units. Granted I do not read anywhere near all the posts on here, but I have only seen it for smaller SFR's and 4 plex or smaller. I am not going to get into the other argument as the biggest I have ever bought at once was a 7 unit. I can assure you I did the calculations completely wrong. It is a great investment so far but I don't think I will ever be able to get the utilities split up.
@Account Closed - I do not comment on anything involving 50% rule, or any other rule, because those are such BS that I can not take a minute of my time to acknowledge. You are right - I never comment on those :)
That, however, has nothing at all to do with your comment and my response to it... Better luck next time :)
@Account Closed - I do not comment on anything involving 50% rule, or any other rule, because those are such BS that I can not take a minute of my time to acknowledge. You are right - I never comment on those :)
That, however, has nothing at all to do with your comment and my response to it... Better luck next time :)
Cap rate & GRM. I'm on track. Now please update on the furnaces in your example.
The cost of running those is passed along to tenants. Separate furnaces presumes separated gas lines/meters, and dedicated climate controls for each unit. All of the cost is passed along...
I am not suggesting that i'd do it - it's not often cost effective. But, in my example I mentioned that the previous guy did it :) Or, that was the original HVAC system.
RUBS on a small multi does not easily work. And even if so, it's hard to recover more than 60% of the cost.
As such, the NOI on the building with separate HVAC systems is more attractive to tenants and owners - wahoo!
BEN, if certain expenses are being collected out side the rents then the properties are NOT comparable for purposes of a GRM comp. Why is a tenant paying the same rent as someone that is getting "free" heat? It would help if you were clearer as to who is paying what to who. Are the tenants paying to the utility or to the landlord?
@Account Closed
- I've leaned from watching you and J dance - I am outa here :)
BEN, if certain expenses are being collected out side the rents then the properties are NOT comparable for purposes of a GRM comp. Why is a tenant paying the same rent as someone that is getting "free" heat? It would help if you were clearer as to who is paying what to who. Are the tenants paying to the utility or to the landlord?
Bob,
At the risk of catching-one for stepping into the dance between you and Ben, I would offer up that the amount of rent being paid is the same, or close enough not to account for the heat being included {it's never free ;-)}, due to the business model of the current owner and the appetite of the market.
We encountered this phenomenon quite frequently when looking at 30-40yr+ old properties. We looked at two last summer - identical builds, constructed in 1969 & 1970, 24-units each. Both had underwent fairly recent renewals of the units (5yrs), but one was still operating with a common boiler, albeit upgraded to a fairly efficient natural gas boiler, while the other had been converted to electric resistance heating about 20years ago, putting the costs of heating in the hands of the tenant. The rent roll at building with the common boiler was ~4% greater than the rent roll where the tenants paid their own way.
Meanwhile, the operating costs on the first building (with boiler) were 64% of gross revenue while the second building had an operating cost ratio of 46%. The taxes on the two buildings were within 1% of each other, so had no significant impact on the difference in operating cost.
The reason we looked at both properties? A quick swat using GRM showed them to be of equal potential, but full analysis indicated otherwise.
@Account Closed
- I've leaned from watching you and J dance - I am outa here :)
Typical from J and Ali. I'm very surprised that you are throwing in the towel. When I make a statement I back it up and am willing to admit when I'm wrong. I think those are the values I got from being raised in the Midwest. Maybe those values have changed since I left.
J kept changing the parameters (check the thread) and Ali denies her own blog posts (check the thread).
Surely a couple of good looking guys like us can have a civil discussion comparing market valuations using cap rates or GRMs. I hope you reconsider.
@Account Closed the 50% is usually used for the first look on rental units of 4 or less. I do not recall anyone using the 50% rule for larger multi units. Granted I do not read anywhere near all the posts on here, but I have only seen it for smaller SFR's and 4 plex or smaller. I am not going to get into the other argument as the biggest I have ever bought at once was a 7 unit. I can assure you I did the calculations completely wrong. It is a great investment so far but I don't think I will ever be able to get the utilities split up.
@Jerry W I am familiar with the 50% rule. It should only be used to determine if there will be cash flow on a property for those that need/want cash flow. I brought up how it is incorrectly used here by a lot of posters to determine NOI and then calculate a cap rate. My statement her was that most posters do not know how to analyze NOI so they cannot use a cap rate. A GRM is so much easier than using a cap rate on small properties. All of Ben's examples were about 4 plexes. IF you know how to analyze NOI AND have NOI comps then by all means a cap rate would be a bit more accurate but hardly worth the effort on small residential properties. Reread both our posts.
Haha - we may both be good-looking, @Account Closed . In fact, not "may" at all in my case. But, I am not interested in mile-long threads which do nothing but aim to establish which one of us can eat a longer hot-dog faster...if you know what I mean. I don't eat processed foods - done :)
I am fully aware of your knowledge base, Bob. You stand out in the crowd. I am simply not here to argue :) Just repeat - Ben is right, and I am wrong...
BEN, if certain expenses are being collected out side the rents then the properties are NOT comparable for purposes of a GRM comp. Why is a tenant paying the same rent as someone that is getting "free" heat? It would help if you were clearer as to who is paying what to who. Are the tenants paying to the utility or to the landlord?
Bob,
At the risk of catching-one for stepping into the dance between you and Ben, I would offer up that the amount of rent being paid is the same, or close enough not to account for the heat being included {it's never free ;-)}, due to the business model of the current owner and the appetite of the market.
We encountered this phenomenon quite frequently when looking at 30-40yr+ old properties. We looked at two last summer - identical builds, constructed in 1969 & 1970, 24-units each. Both had underwent fairly recent renewals of the units (5yrs), but one was still operating with a common boiler, albeit upgraded to a fairly efficient natural gas boiler, while the other had been converted to electric resistance heating about 20years ago, putting the costs of heating in the hands of the tenant. The rent roll at building with the common boiler was ~4% greater than the rent roll where the tenants paid their own way.
Meanwhile, the operating costs on the first building (with boiler) were 64% of gross revenue while the second building had an operating cost ratio of 46%. The taxes on the two buildings were within 1% of each other, so had no significant impact on the difference in operating cost.
The reason we looked at both properties? A quick swat using GRM showed them to be of equal potential, but full analysis indicated otherwise.
@Roy N Just as in Ben's example you were NOT comparing comparable buildings. Now you could use the market GRM's if all you had were buildings with central boiler heat and SUBTRACT the cost to retrofit that property to individual meters. That is done all the time when your GRM comps are all in good condition and your property needs say a $20,000 new roof. Now using a cap rate will not account for that roof unless you are smart enough to do a below the line adjustment. Both methods will NOT give you market value to the penny. No matter how you are doing it you will still need to make adjustments to market value.
Now if all your GRM comps had the separate furnaces then the GRM would be accurate for that property but need an adjustment for the boiler property. GRM's, so easy a caveman can use it.
@Account Closed
That was precisely the point. The two buildings were not the same when you looked closer. Simple ratio comparisons are precisely that, "simple", sometimes dangerously so, and GRM amongst them. It is a blunt instrument, useful enough to weed out the ridiculous propositions, but not something upon which I would base an offer.
In reality, you need to compare what is available in the market and, most of the time, no two buildings are exactly identical, therefore one needs to learn how to perform rigorous analysis be able to determine an appropriate price to pay for a given business.
I believe I started this heated and very informative exchange of ideas, and I am not sorry. I believed that GRM was just a different way of beginning the process of Due diligence. Just as CAP and ROI it was just a parameter that was used to ferret out possible good deals. Nothing replaces accurate numbers, Its just another tool to use to determine your local market. The more info the better. There is no easy way. You must do the leg work, But if mastering the GRM in your area can save you the time. I believe.
Hahahahahaha..... Can I add to the fire?
I think cost per unit is a better way to start....
In a simple world with true, honest, and accurate data that was put into play through some sort of operations that could be rated on efficiency, cap rate would be the best way. But, that is not what we have.
It really does not matter what method that you use. The key is to root out the deals and then spend the time on a real evaluation.
@Account Closed Hate to jump in late to the party but ... the use of GRM to value Multifamily property (particularly larger multifamily property) is useless at best, dangerous at worst. The "secret sauce" to this investment class is understanding expenses (and buying right). That is done by knowing all details of expenses and underwriting accordingly. I disagree that this is an unknown at time of purchase. No, the sellers expenses will not be reliable but with experience a savvy buyer can figure it out. Unfortunately this is exactly where most investors fail miserably. They use GRM and the 50% rule and think where can I go wrong. Its very easy to have 70%-200% expense ratios when it is impossible to maintain occupancy or you have D class tenants. No GRM or 50% rule will account for this. This is the primary reason so many large multifamily properties fail and guys like @Ben Leybovich buy them. The difference is the new buyer understands the expenses and buys it for the according value rather than a target GRM or a broker pro-forma.
There are so many factors that determine a building's value that gross rents tell literally nothing of the real story. The story is told in the occupancy, expenses, owner and location. Each of those will equate a value but you cannot assign a value until all four are figured out.
The 50% rule is just as general of a metric although more useful to get a quick estimate of NOI. I see literally no value in GRM other than a cursory evaluation of homogenous SFR stock in one location. Unfortunately @Ben Leybovich is correct here.
@Account Closed Hate to jump in late to the party but ... the use of GRM to value Multifamily property (particularly larger multifamily property) is useless at best, dangerous at worst. The "secret sauce" to this investment class is understanding expenses (and buying right). That is done by knowing all details of expenses and underwriting accordingly. I disagree that this is an unknown at time of purchase. No, the sellers expenses will not be reliable but with experience a savvy buyer can figure it out. Unfortunately this is exactly where most investors fail miserably. They use GRM and the 50% rule and think where can I go wrong. Its very easy to have 70%-200% expense ratios when it is impossible to maintain occupancy or you have D class tenants. No GRM or 50% rule will account for this. This is the primary reason so many large multifamily properties fail and guys like @Ben Leybovich buy them. The difference is the new buyer understands the expenses and buys it for the according value rather than a target GRM or a broker pro-forma.
There are so many factors that determine a building's value that gross rents tell literally nothing of the real story. The story is told in the occupancy, expenses, owner and location. Each of those will equate a value but you cannot assign a value until all four are figured out.
The 50% rule is just as general of a metric although more useful to get a quick estimate of NOI. I see literally no value in GRM other than a cursory evaluation of homogenous SFR stock in one location. Unfortunately @Ben Leybovich is correct here.
I'm not sure what you think I'm wrong about or what Ben is correct about as your post is vague. My statement is that using GRM's is probably the best way to determine market value of multi families other than direct sales comparison for at least 90% of the investors here. Would you like to step in and take Ben's side of this discussion?
@Account Closed @Serge S. @Ben Leybovich @Steve Olafson
For what it's worth...I'm part of a two person acquisitions team at my company and we've purchased 15 large multifamily properties (~3,400 units) since mid-2012. I have sourced, underwritten, negotiated, and closed several of these transactions. I could not tell you the GRM on any of these deals, nor did I ever look at it.
What do I look at? Price per unit, comparable sale price per unit, COCR, cap rate and to a lesser extent levered IRR.
What do I look at? Price per unit, comparable sale price per unit, COCR, cap rate and to a lesser extent levered IRR.
All the same things that I look at in exactly the same order. I start with the price per unit because that is easy to see. I then look at any variances like unit mix, location, w/d hookups, etc for adjustments. I only look at cap rate for my own proforma or if I really need it for negotiations. The cap rate, COC, and IRR all show up on my evaluation spreadsheet. I pay attention to them if they seem out of whack.
When you are constantly looking at properties to purchase, you need to be efficient at rooting them out quickly. I am calibrated for the cost per unit evaluation and it works very well for me.
@Account Closed @Serge S. @Ben Leybovich @Steve Olafson
For what it's worth...I'm part of a two person acquisitions team at my company and we've purchased 15 large multifamily properties (~3,400 units) since mid-2012. I have sourced, underwritten, negotiated, and closed several of these transactions. I could not tell you the GRM on any of these deals, nor did I ever look at it.
What do I look at? Price per unit, comparable sale price per unit, COCR, cap rate and to a lesser extent levered IRR.
Are you saying GRM's are useless to the 90% of posters here that will never buy more than say 8 units? Reread and see where Ben made an attempt to debunk GRM's utilizing a 4 plex.
@Account Closed No. I'm not saying they are useless. I'm just saying there are far better metrics to use when evaluating multifamily property. I'm not here to pick a fight or argue, just read the thread and thought my experience might have some value. That's it.
@Account Closed No. I'm not saying they are useless. I'm just saying there are far better metrics to use when evaluating multifamily property. I'm not here to pick a fight or argue, just read the thread and thought my experience might have some value. That's it.
@Sean S. What metrics are far better to determine market value for 4 plexes that could be utilized by the average BP poster? The discussion was because two posters said GRM's were useless for this purpose. You even agree that you are not saying they are useless and I just wanted to confirm that as your post wasn't clear. No fight or argument from me just the facts.
Nice... Good stuff for sure.. Definitely walked away with a better understanding of the types of metrics used to analyze deals. Thanks everyone!