Cap Rate Dilema in multis

15 Replies

I'm looking at a bunch of multi-families in different cities, and a lot of them are 4 or 5% cap rate in B areas that sell really fast. 

My point is, I understand that you get lower cap rate areas at A or B areas, but with such low cap rates you're certainly having a negative cashflow at 5% rate with 25% down at 25 years. 

Would love to hear from people who bought similar cap rate properties, what your strategy was to buy such low cap rate properties and how it worked out. 

Most likely no one will be able to answer this question because no one was buying at 4%-5% caps three years ago, and with most assets being held 3+ years the 4%-5% acquisitions haven’t sold yet.

Having said that, 3 years ago when people said it was crazy to buy at 5%-5.5% caps, I've since made out pretty well on those trades, some of them exceeding 30% gross IRR on full cycles. But here's the rub: cap rates compressed to 4% since buying those, and that certainly contributed to the home-run style outcomes. Will today's 4%'s trade out at 3% in three years? I doubt it. But I've said that before, too...

I'm still buying today, and I think we'll do very well. Not 30%+ IRR well, but still double digits. To your point, 75% leverage doesn't always work—65% is common. And not 25-year am...more like 5 years of I/O followed by 30-year am. That gives time for the cash flow to ramp, which is the thesis behind low cap rates—rent growth makes the income stream more valuable.

@Daniel Suarez

That’s a great question.

The loan terms you mention specifically the amortization period are typical for commercial bank loans under $1,000,000 where 20 to 25 year amortization schedules are the norm.

Yes hard to cash flow with a 20 or even 25 year amortization.

@Brian Burke mentions there are loans with interest only periods and then 30 year amortization. These are so called agency loans made by Freddie Mac and Fannie Mae and are generally only available on loan amounts above $1,000,000.

We are closing a 43 unit acquisition with a Freddie loan today with a sub 4% rate and one year interest only.

Agency debt is not easy to get - one must have prior agency debt experience to get an agency loan - not to mention high net worth and lots of liquidity.

One might logically ask about this seeming Catch 22 - if you need agency debt experience to get an agency loan, how does one get agency debt with no agency debt experience?

Answer: Find a key principal and loan guarantor to sign on loan with you.

That’s a topic for a different thread.

Keep educating yourself, network and talk to lots of people and you can figure out how to do it.


Thanks so much Brian! I haven't paid attention to IRR before. I was only looking at cash on cash and cap rate numbers. I'll definitely pay more attention to it.

Interesting, so a lot of people are buying 5% cap rates with the hope that it might be a 4% cap rate in the future?


I only have one multi family currently in C area Oklahoma that cap rates about 11%. I thought most commercial loans were similar (mine was 25 down for 25 years at 5.5%) I guess the better the area the better the interest rate you get, also maybe less vacancy?

Would you mind sharing numbers of a recent deal you made and how that's doing so far? 

Thanks so much!

Hello. Just ran into that juncture this week. A 60 unit building w/ selller´s asking price at $5,250,000, year 2020 NOI at $319,647. When including property management (not built into seller´s NOI), and financing at 3% 30 yrs. 20% down, the purchase cap rate results at 4.42%, CoCROI results in 1.63%, and monthly cash-flow at $1,626. I understand there is a lack of inventory, but how do you make sense of these numbers for a viable deal?

Best,

JCG

Thanks so much Arn, that is really good to know. I haven't heard of agency loans before, something to look at. I'll definitely do some research on loan guarantors as well. 

Depending on how large the asset is, you may be competing with intuitional money: think insurance companies with huge piles of cash from collected premiums that needs to be invested. They don't care about low CAP rates. They care about investing their cash to throw off enough regular cash returns so they can pay out claims. All cash deals cash flow just fine at 4 CAPs in those circumstances.

Some people are investing in bank CDs still, paying a meager 1%.  Some still have passbook savings accounts at less than 0.5%.  They consider capital preservation more important than making any return, which is ironic since inflation is eating up their purchasing power.  A wise investor might ask some of those folks if they'd rather earn 3% on an investment secured by real estate.  A spread of 2.5% (5 x what they're getting today) might look very attractive, and still leaves 1% for the deal maker.  

Then again, there are lots of people with cash right now looking to exchange up before the current administration tries to close down the 1031 exchanges.  You might simply be outbid by individuals who can put down 40% or more.

Consider looking at asset classes that aren't in a feeding frenzy right now.  Almost everyone on BP is gaga over MF units.  Why not look at something very "earthy" like automotive repair shops and/or warehouse space?  Less competition = better deals, I've found.

@Daniel Suarez , regardless of size, cap rates are squeezed, particularly in multifamily.  There is more to your return than cap rate, as Brian added.  In fact, if you only look at cap rate and cash on cash yield, with no other influence on returns (rent growth, appreciation, etc), then real estate isn't that great of an investment. 

But, as Erik mentions, there is a lot of real estate out there that isn't multifamily. Office, industrial, hotels, retail, etc. In many cases these are better investments: longer term leases, no tenant calls at 3am (at least for office, industrial, retail), tenants often sign NNN leases so they cover your insurance, taxes and common area maintenance. But financing is also less favorable, typically higher rate and with personal guarantees.

@Loria Smith

Hello Loria.  When the seller says cap rate at 6%, you should expect $5,000 in monthly cashflow from your $1 M. down out-of-pocket.  Now, if you are a sponsor putting together the deal with OPM (other peoples´s money), then your deal strategy may make sense under your target financial metrics.  I think the other posts on this thread better explain how the investment market is reacting as the world turns.

Best wishes in your RE journey!

Originally posted by @Brian Burke :

Most likely no one will be able to answer this question because no one was buying at 4%-5% caps three years ago, and with most assets being held 3+ years the 4%-5% acquisitions haven’t sold yet.

Having said that, 3 years ago when people said it was crazy to buy at 5%-5.5% caps, I've since made out pretty well on those trades, some of them exceeding 30% gross IRR on full cycles. But here's the rub: cap rates compressed to 4% since buying those, and that certainly contributed to the home-run style outcomes. Will today's 4%'s trade out at 3% in three years? I doubt it. But I've said that before, too...

I'm still buying today, and I think we'll do very well. Not 30%+ IRR well, but still double digits. To your point, 75% leverage doesn't always work—65% is common. And not 25-year am...more like 5 years of I/O followed by 30-year am. That gives time for the cash flow to ramp, which is the thesis behind low cap rates—rent growth makes the income stream more valuable.

Great points!  

Simple explanation is not every cares about CAP rate based on 25% down at 5% interest for 25 years. Some people pay all cash and are happy with secure 4%. Some people put more money down. Some people have better interest rate or longer term. Some people make their money through exit strategy. Some people perform value add improvements to increase rent and cash flow. Some people are ok breaking even or even taking a loss to offset other income. Some people acquire today with expectation of future cash flow. Some people make irrational or even bad investment decisions.

There is any number of reasons someone may do a deal that you chose not to do. 

CAP rate compression puts even more pressure on market rents to increase. As more properties are purchased at higher prices, more investors increase rents to make profit. Looking at it another way, when cost to acquire goes up, so do rents.

I wouldn't buy a 5% cap rate property. Probably not even a 19% cap rate. I can make better returns on single and small multifamily.

Updated about 1 month ago

10% cap rate,.not 19%