Cap rate expectations

14 Replies

Cap rates have compressed over time. Locally in the Chicago suburban market, a 6% cap rate is common and to be expected. With rising interest rates, I've heard push back that cap rates don't make sense and deals aren't "good", especially if there isn't a big value add opportunity. For those in growth mode, how do you counter the cap rate concern?

@Steve G. I don't buy properties with low cap rates if there is no room to push them up with repositioning. 

With continued increase in interest rates, Cap rats compression will slow down in the hot premium markets. and are likely to rise in most other markets. 

This trend is cyclical and happened before.

Just be patient and don't over pay.

Cap rates in the 6% range are common all around the country. That said, cap rate isn’t a measure of deal quality. Cap rate is a fairly useless measurement in deciding how much to pay for a property or how well it will perform.  The only real use for cap rate is to estimate how much you can sell the property for when you go to sell one day.

That’s not to say that the threat of cap rate decompression isn’t real—it is. When we buy we plan our exit caps to be higher than today’s prevailing cap rates to account for that decompression.

@Steve G. Look for higher rent rents via non-traditional/modern rentals:

- AIrbnb/STR

-Leasing fully furnished

-Rent by the room/Student hosuing

-Assistance living, etc.

-properties with deeded parking can be rent on spothero for additional income

I found (as the everyone else knows, no secret) you can get higher rental rates with more active leasing methods. Passive income is capped by the market.

Taken me a while to "get it" but agree with @Brian Burke , cap rates are relatively meaningless when you are underwriting the PP of a property because of all of the variables.

We will underwrite the building using solid/conservative information on gross income (what are market rates, can we raise rents over 2-3 years, what reno needed to get to market, how do are units stack up compared to others, what is market vacancy, etc.), what we can achieve not what the current owner has done.   Sometimes there is upside, sometimes there is not.

On the expense side, same thing. Conservatively underwrite based on a combination of actuals and market knowledge. Can we lower utility costs with energy efficient fixes? Are taxes going to go up in a couple of years after purchasing the building? What is the per unit expense cost? Is the current owner just bad at running a building?

Overall, the idea is that you might be buying a building at a 6% cap rate (or less) but when you underwrite conservatively using market data that you know and are comfortable with, you can run the building better than the current owner, make the building cash flow and effectively making it maybe a 9 or 10 cap building.

A good example. One of the buildings we're buying is a 29 unit on the south side of Chicago. The OM was something like a 7 cap on actuals and a 8.5 cap on proforma. All of this is BS information. In reality, the current owner is losing a lot of money every month. He's in a death spiral because he doesn't want to put more $ in to the building so his occupancy is dropping (around 65% right now) and his tenant quality is dropping. His current strategy is not working and will never work. Working with a PM that specializes in this area, we have a strategy that involves complete reno of units, combo of section 8/market tenants, getting rents to market and offering a quality living space that attracts better tenants. 

Long story short, we're technically buying at a -7% cap rate but feel comfortable being able to stabilize this asset within 3 years to have it running at around a 9% cap rate (based on our PP) with upside. Current cap rates on stabilized buildings in this area (Jackson Park) are around 7%, just to give perspective. 

@Scott Skinger I'm glad you posted this, I've noticed lately the agents seem to have no idea what they are putting in the OM and the actual numbers, tenancy, and condition of the building are nothing like the building on paper. You really have to do your due diligence to look at the property and ask to review leases and actual expenses. 

@Steve G. Yes, the cap rates being offered on properties today are far lower than we were getting all around the city a year ago. If you are buying market rate properties, you are looking at a lot of 6 and 7 caps right now. I think what many of the other contributors are saying is value add properties should be the focus. Either upgrading the units or just better management of the property and lowering expenses. 

I bought in Oklahoma City 5 years ago at a 15% cap rate! Now it’s hard to find value adds that can match that. And that’s been my best performing multifamily investment. The real returns are in owner finance though!
Originally posted by @Hadar Orkibi :

@Steve G. I don't buy properties with low cap rates if there is no room to push them up with repositioning. 

With continued increase in interest rates, Cap rats compression will slow down in the hot premium markets. and are likely to rise in most other markets. 

This trend is cyclical and happened before.

Just be patient and don't over pay.

 Hadar, I disagree. I think interest rates aren't impacting cap rates nearly as much as some are saying. Rates are almost guaranteed to rise, but I don't necessarily see cap rate compression slowing because of that. The real money/moves are going to be made by those able to buy unleveraged. It's hard to find deals right now, but if you're the bank (cash purchase) or you don't care if your returns top 7 or 8% (institutional buyers) then you're going to clean up nicely because competition has greatly slowed.  

@Lucas Miller i have seen it first hand last cycle, end hear from fellow investor in Texas (one of the hottest market in the country) that ca prat compression have slowed down. 

I do still think that Texas and Florida for example have room to grow because of the strong population and jog growth. 

would it become another LA. SF, or NY, Time would tell. (ie.. Capital growth market with low yields.)

Im not sure that your post is 100% clear to me, 

"if you're the bank (cash purchase) or you don't care if your returns top 7 or 8% (institutional buyers) then you're going to clean up nicely because competition has greatly slowed. " 


Cleaning 7%-8% on what? but anyway its sounds  good, the top markets like DFW, LA etc are priced at 4%-5%, mage 6%. for A -B products unless you see rent growth (which is slowing down) how much cash flow or equity growth are you seeing in the medium term? 


Time would tell I guess.

Put another way, if you're buying an asset with cash, or some other way that's not tied to bank's interest rates, you're going to do better than someone like myself still using traditional commercial lending. That's all I was saying. I have no doubt that cap rate compression will slow, I just don't think interest rate spikes are totally to blame. 

@Lucas Miller its not total to blame but its main factor, if the cost of the investment raises then something have to change. unless the investment become a better grade asset. 

like a market that is maturing and becoming Premium market like DFW for example, the base line of return is lower and will stay lower moving forward. 

Cash is always King, and that's why many overseas buyers and investment founds can pay more for assets. - but it doesn't make it a better deal in my opinion. 

Many of the above over pay and have a long time-frame... to "mitigate the risk" 

I guess there are many ways to skin the cast....

Im using leverage and in it for the cash-flow and forced appreciation, not land banking and hoping.  that's lazy money in my opinion. 

Cheers

@Hadar Orkibi I agree with you are saying - logically. It is commendable that you (like I sometimes try to do) are using rationality as the basis for your investment thesis. But Keynes has a great quote that sums up the current madness: "The market can remain irrational longer than you can remain solvent."

Most syndicators/"investors" are buying at or above market because they are playing the momentum game i.e. prices have gone up in the past 4-8 years, hence, prices will continue to go up. 

Which means in my preferred markets (TX and FL) that so far rising interest rates have not dampened (as much as expected) the cap rates. If anything, in certain markets, rates are rising and cap rates are compressing (still!). 

I don't know what geniuses are buying these assets and more importantly, who are the smart folks investing capital into these deals... but they are happening.

I won't touch these deals but we will know who made the right (or lucky) bet in the next  few years. Maybe, we're all wrong and it's still time to go all in. Who knows?

@Omar Khan Great points and the dilemma at hand for many. Sit on the sidelines, pass on many deals or accept a lower return rate and continue increasing cash flow across an expanding portfolio. If you're happy with current portfolio and cash flow, it's easy to sit tight until you find a great match or until market turns. If looking to grow though, I think it's a matter of whether or not you're willing to accept a lower return and work with smaller margins.

The three factors that derive Cap Rate are risk free rate + risk premium, NOI growth, and liquidity of the asset. Let's use the 10 year treasury yield as the risk free rate and assume the assume the risk premium is fixed for simplicity. An increase in interest rates will lead to an increase the 10 year treasury yield, and thus the risk free rate increases. This would lead to a higher cap rate all else being.

However, in our current market rents are still going up, vacancy is low, and real estate is relatively liquid, which leads to lower cap rates.  As @Hadar Orkibi said though this trend is cyclical. We'll reach a point where NOI stops growing and banks tighten the money they lend out, and all three factors will point to higher cap rates.