Sometimes I feel very dumb (CAP Rate edition)

13 Replies

Hello beautiful people of BP, 

Today is one of those days that made me feel dumb. But the good news, I finally "get" something instead of just knowing about it. 

For a long while, I felt that way about Return On Equity calcs. I knew how to run the calc, but I didn't really know what it truly meant. That's another discussion, if  you're new, and don't understand what ROE really means, learn it. 

But to my dumb-me point. Today's aha moment is about CAP rates. I've long understood how CAP rates work, and how larger commercial properties are governed by market CAP rates. What I could never wrap my head around for some reason (open mind but thick skull) was how people....and WHY people would buy at these seemingly insane low CAP rates. And there probably are multitudes of reasons. But one reason became obvious to me today.

At low CAP rates, operational improvements are more valuable than ever. Not cashflow, though. For cashflow purposes, reorganizing a multifamily to perform better is always worth what it's worth. For instance, if you can save, or earn, an extra $50k per year by improving the operation, it's worth exactly $50k (ignoring taxes and such).

But here's the real kicker, in an 8 CAP market, that $50k extra per year increases the sale price by $625k. Not bad. In a 4 CAP market, it raised the price to $1.25M. Fantastic. So buying the same property in the 4 CAP market would make the buyer (on the tail end) more money in the low CAP market than it would have made in the 8 CAP.

There are obviously other considerations like you should cash-flow better when purchasing in the higher CAP rate market (or time line). And it really applies to shorter term holds vs long term holds. However, identifying mismanaged, under market rent properties in a low CAP market is more valuable than finding them in buyers high CAP market.

And if I'm wrong, mods feel free to delete this thread haha. My face does not prefer eggs. :) 

@Dustin Beam you eluded to a key point regarding cap rates; they’re a kind of nebulous metric because they can fluctuate largely depending on how the property is operated. This is why we use gross rent multiples and price per unit metrics alongside of cap rates when valuing deal (not to mention stabilized forecasts).
Originally posted by @Troy Beebe :
@Dustin Beam you eluded to a key point regarding cap rates; they’re a kind of nebulous metric because they can fluctuate largely depending on how the property is operated. This is why we use gross rent multiples and price per unit metrics alongside of cap rates when valuing deal (not to mention stabilized forecasts).

From what I understand, CAP rate is a market force. So it fluctuates across the board, but not per property. Meaning, CAP rate does not fluctuate per property. Instead, your sale price fluctuates based on your income. Now I realize someone could be selling at a higher or lower CAP rate than the market force is justifying, but ultimately CAP rates are independent of any given property.

The point I was making is that while I understood that if NOI increased X amount, the property value increased accordingly based on whatever the market CAP rates are in that given area and time. What I was not able to comprehend, is how people were buying in a 5 CAP. I mean, that's 5% profit on investment if you pay all cash. If you're not paying cash, the PITI would eat up that 5% almost assuredly leaving you without cash flow. The part I neglected was how much more attractive a mismanaged property is in a low CAP market than it is in a high CAP market, depending on goals.

One reason this mental hurdle was hard for me is that I'm still relatively new and really focusing on cash flow. So I had this barrier where I kept pointing to cash flow and thinking "there's no way those CAP rates work unless it appreciates!". But I was wrong. I would still say I can't see how buying at those low CAP rates work if it's already running like a top and it doesn't appreciate. But I can see the light on how attractive a mismanaged property can be if mismanaged in a low CAP market on a 3-5 year "flip".

@Dustin Beam A cap rate is just a math problem; not quite a market force, because they fluctuate so much and again are determined largely by how the property is being run.

Remember, there are a number of ways to play the game, and not everyone is aiming for the 3-5 year flip. For example, we just sold a 21-unit apartment property to a private investor at a 4.56% cap rate. The market that this particular property was in commands cap rates in the 6%-7% range. The reason this investor paid a premium is because they're looking at this property over the long term. The property was impeccably maintained; and the reason it was such a low cap rate at the time of sale was because the rents had been kept artificially low by the sellers of the property who had owned it for 40 years. While the new purchaser of the property is entering it at a current 4.56% cap rate, by years 3 to 4 they're going to be at a solid 7%-7.25% cap rate and it will be a great long-term investment for them with potential for appreciation as well. 

While I can't speak for other markets, I can tell you that anyone who is walking into an 8%+ cap rate building, for the most part, in the Chicagoland market is buying in an area that is not increasing in value and will not see much appreciation if any. Cashflow and appreciation tend to work in opposite ways...the more of one, the less of another. The trick is finding the gems that allow you to achieve the most of both.

Originally posted by @Troy Beebe :

@Dustin Beam A cap rate is just a math problem; not quite a market force, because they fluctuate so much and again are determined largely by how the property is being run.

Remember, there are a number of ways to play the game, and not everyone is aiming for the 3-5 year flip. For example, we just sold a 21-unit apartment property to a private investor at a 4.56% cap rate. The market that this particular property was in commands cap rates in the 6%-7% range. The reason this investor paid a premium is because they're looking at this property over the long term. The property was impeccably maintained; and the reason it was such a low cap rate at the time of sale was because the rents had been kept artificially low by the sellers of the property who had owned it for 40 years. While the new purchaser of the property is entering it at a current 4.56% cap rate, by years 3 to 4 they're going to be at a solid 7%-7.25% cap rate and it will be a great long-term investment for them with potential for appreciation as well. 

While I can't speak for other markets, I can tell you that anyone who is walking into an 8%+ cap rate building, for the most part, in the Chicagoland market is buying in an area that is not increasing in value and will not see much appreciation if any. Cashflow and appreciation tend to work in opposite ways...the more of one, the less of another. The trick is finding the gems that allow you to achieve the most of both.

 Right, I understand that. 

And your buyer is doing exactly what I was saying. He/she will increase the NOI to a point that it hopefully is cashflowing regardless if financed, and then if he/she sells, I bet they don't sell at the new CAP rate (based on purchase), but I bet they sell at the market CAP rat for a nice return. They bought at what appears to be a terrible purchase, but they identified how it was mismanaged, thus will improve the value of the property immensely.

You're correct, they would sell at a new market cap rate, but I'm not sure there is as much of a gain (at least with this deal) because in order to increase the NOI, you're likely going to have to spend some money to do so.

See the attached image. If market cap rates are 6%-7%, this deal (once stabilized) should be able to sell for somewhere between $2,166,971 to $2,528,133. That is quite the spread. Let's say it settles at 6.5% cap rate, or $2,333,661 sales price. That may seem like a good return - $238,661 profit - but it is unlikely the new owner is going to be able to raise the income to the 'Stabilized' level without spending some money along the way through renovating units or general building maintenance. How much is the question...and this is where good deals are won or lost. 

Originally posted by @Troy Beebe :

You're correct, they would sell at a new market cap rate, but I'm not sure there is as much of a gain (at least with this deal) because in order to increase the NOI, you're likely going to have to spend some money to do so.

See the attached image. If market cap rates are 6%-7%, this deal (once stabilized) should be able to sell for somewhere between $2,166,971 to $2,528,133. That is quite the spread. Let's say it settles at 6.5% cap rate, or $2,333,661 sales price. That may seem like a good return - $238,661 profit - but it is unlikely the new owner is going to be able to raise the income to the 'Stabilized' level without spending some money along the way through renovating units or general building maintenance. How much is the question...and this is where good deals are won or lost. 

I had a long post typed out, but I think we have a different idea of how CAP rates are used and there is no use going back and forth on this. It seems like you're implying it's used to evaluate a deal. I'm saying it's used to establish "comps" for a given class of property in a given area/time.

Buying a property at 4.x% CAP when that market says it's 6-7% seems foolish unless a major play could be had to make that up. The numbers you provide show that the buyer will make virtually no money (outside of cashflow difference) by going through the trouble of raising rents, turnovers, etc. I wouldn't do that, but it's JMO.

@Dustin Beam

At 7% market cap rate, buying at 4.5% CAP and "increasing" your cap rate to 7% is not going to increase the value of the property. If at the time of sale, the market cap rate compresses to 4.5% then yes he will make money, but what if market cap rate expands to 9% (i.e. which are long term norms)?

The question is where is the Chicago market cap rate going? Is it more likely going to 4.5%? or 9%? Which is more likely - the economy slowing down, interest rate going up (i.e. cap rate expansion) or -the economy going even hotter and interest rate going down (i.e. cap rate compression)?

Your aha moment is as you described - "market" cap rate. It's a metric that's frequently confused with "cap rate" as it is discussed here on BP. The cap rate that's talked about often here on BP is "property" cap rate (i.e. the one you get by dividing NOI / Cost(Value). The "market" cap rate you are talking about is, as the name suggests, "market" driven or "market" specific. So I agree with you that this cap rate is a market force. It's a barometer of how desirable specific class of properties in a specific market is; which is also a function of how much risks the market attributes to those properties. So this particular cap rate has little to do with how any particular property is being managed. It's more of an economic metric along the lines of unemployment rate, economic growth, etc. It is no coincidence that cap rate (i.e. "market" cap rate) compresses when unemployment rate is low and economic growth is high. Similarly, cap rate tends to expand during bad economic times.

Cheers... Immanuel

Originally posted by @Immanuel Sibero :

@Dustin Beam

At 7% market cap rate, buying at 4.5% CAP and "increasing" your cap rate to 7% is not going to increase the value of the property. If at the time of sale, the market cap rate compresses to 4.5% then yes he will make money, but what if market cap rate expands to 9% (i.e. which are long term norms)?

I know that buying at 4.5 and increasing to 7, in a 7 market, won't increase the value. But that was the point I made in my previous post. The buyer over paid, thus sacrificed the gains he should have made for increasing NOI. He bought poorly IMO, and is a bad example of how to use CAP rates. Market fluctuations also don't pertain to this conversation. Again, my point was only how I realized how someone can make money under low cap rate compression.

The question is where is the Chicago market cap rate going? Is it more likely going to 4.5%? or 9%? Which is more likely - the economy slowing down, interest rate going up (i.e. cap rate expansion) or -the economy going even hotter and interest rate going down (i.e. cap rate compression)?

Your aha moment is as you described - "market" cap rate. It's a metric that's frequently confused with "cap rate" as it is discussed here on BP. The cap rate that's talked about often here on BP is "property" cap rate (i.e. the one you get by dividing NOI / Cost(Value). The "market" cap rate you are talking about is, as the name suggests, "market" driven or "market" specific. So I agree with you that this cap rate is a market force. It's a barometer of how desirable specific class of properties in a specific market is; which is also a function of how much risks the market attributes to those properties. So this particular cap rate has little to do with how any particular property is being managed. It's more of an economic metric along the lines of unemployment rate, economic growth, etc. It is no coincidence that cap rate (i.e. "market" cap rate) compresses when unemployment rate is low and economic growth is high. Similarly, cap rate tends to expand during bad economic times.

A property CAP rate only lets you know if you bought better or worse than the market suggested you should have, or what you should list a property for. Of course the property CAP rate does not show how it's managed. You can assign the CAP rate to any property simply by adjusting the asking price. But that's not the point, is it? The point of calculating a CAP rate on a certain property is to ascertain the value of what the sale price SHOULD BE if you're selling, or to justify how good a bargain it is. It's not a substitute for how well a property performs. A whole separate profit analysis should be done for that.But again, this thread is devolving into the definition of what CAP rates is, and that was never the intention. 

Mine in bold.

Originally posted by @Dustin Beam :
Originally posted by @Immanuel Sibero:

@Dustin Beam

At 7% market cap rate, buying at 4.5% CAP and "increasing" your cap rate to 7% is not going to increase the value of the property. If at the time of sale, the market cap rate compresses to 4.5% then yes he will make money, but what if market cap rate expands to 9% (i.e. which are long term norms)?

I know that buying at 4.5 and increasing to 7, in a 7 market, won't increase the value. But that was the point I made in my previous post. The buyer over paid, thus sacrificed the gains he should have made for increasing NOI. He bought poorly IMO, and is a bad example of how to use CAP rates. Market fluctuations also don't pertain to this conversation. Again, my point was only how I realized how someone can make money under low cap rate compression.

The question is where is the Chicago market cap rate going? Is it more likely going to 4.5%? or 9%? Which is more likely - the economy slowing down, interest rate going up (i.e. cap rate expansion) or -the economy going even hotter and interest rate going down (i.e. cap rate compression)?

Your aha moment is as you described - "market" cap rate. It's a metric that's frequently confused with "cap rate" as it is discussed here on BP. The cap rate that's talked about often here on BP is "property" cap rate (i.e. the one you get by dividing NOI / Cost(Value). The "market" cap rate you are talking about is, as the name suggests, "market" driven or "market" specific. So I agree with you that this cap rate is a market force. It's a barometer of how desirable specific class of properties in a specific market is; which is also a function of how much risks the market attributes to those properties. So this particular cap rate has little to do with how any particular property is being managed. It's more of an economic metric along the lines of unemployment rate, economic growth, etc. It is no coincidence that cap rate (i.e. "market" cap rate) compresses when unemployment rate is low and economic growth is high. Similarly, cap rate tends to expand during bad economic times.

A property CAP rate only lets you know if you bought better or worse than the market suggested you should have, or what you should list a property for. Of course the property CAP rate does not show how it's managed. You can assign the CAP rate to any property simply by adjusting the asking price. But that's not the point, is it? The point of calculating a CAP rate on a certain property is to ascertain the value of what the sale price SHOULD BE if you're selling, or to justify how good a bargain it is. It's not a substitute for how well a property performs. A whole separate profit analysis should be done for that.But again, this thread is devolving into the definition of what CAP rates is, and that was never the intention. 

Mine in bold.

Agree with everything you said above!!

I incorrectly interpreted that you had just discovered "market" cap rate in general... Now I realize that you understand cap rate and simply had an aha moment on a small aspect of market cap rate (should've known this from your post count...lol). I see it as a coin with two opposing sides - a low cap rate is bad because of high acquisition price but good because improvements are valued high, a high cap rate is the exact opposite.

However, I have also seen fully updated properties with virtually no value add/improvement opportunities going for insanely low cap rate here in some DFW areas. The basis for these sales is simply bullish expectations on the local economy - insane rent increase. Basically some investors think they can buy at insanely low cap rate, but with insane rent increases they will still make insane amount of money without doing anything... lol.

My comment about property CAP rate not relfecting how the property is managed is more directed to the other poster. As you pointed out, cap rate discussion tends to degrade into its most elemental level. It's a reflection of how misunderstood cap rate is. Feels like it is the only area in which I'm interested enough to make a post. I'm a newbie and learning :-)

Cheers... Immanuel

Originally posted by @Dustin Beam :
Originally posted by @Troy Beebe:

You're correct, they would sell at a new market cap rate, but I'm not sure there is as much of a gain (at least with this deal) because in order to increase the NOI, you're likely going to have to spend some money to do so.

See the attached image. If market cap rates are 6%-7%, this deal (once stabilized) should be able to sell for somewhere between $2,166,971 to $2,528,133. That is quite the spread. Let's say it settles at 6.5% cap rate, or $2,333,661 sales price. That may seem like a good return - $238,661 profit - but it is unlikely the new owner is going to be able to raise the income to the 'Stabilized' level without spending some money along the way through renovating units or general building maintenance. How much is the question...and this is where good deals are won or lost. 

I had a long post typed out, but I think we have a different idea of how CAP rates are used and there is no use going back and forth on this. It seems like you're implying it's used to evaluate a deal. I'm saying it's used to establish "comps" for a given class of property in a given area/time.

Buying a property at 4.x% CAP when that market says it's 6-7% seems foolish unless a major play could be had to make that up. The numbers you provide show that the buyer will make virtually no money (outside of cashflow difference) by going through the trouble of raising rents, turnovers, etc. I wouldn't do that, but it's JMO.

Dustin, I don't disagree with you, they're certainly used as comparable information, but they're also used when evaluating the deal. Both applications are correct. Regarding your second point, I would argue it is only foolish to someone who isn't planning on owning the building for a long period of time.

Originally posted by @Troy Beebe :
Originally posted by @Dustin Beam:
Originally posted by @Troy Beebe:

You're correct, they would sell at a new market cap rate, but I'm not sure there is as much of a gain (at least with this deal) because in order to increase the NOI, you're likely going to have to spend some money to do so.

See the attached image. If market cap rates are 6%-7%, this deal (once stabilized) should be able to sell for somewhere between $2,166,971 to $2,528,133. That is quite the spread. Let's say it settles at 6.5% cap rate, or $2,333,661 sales price. That may seem like a good return - $238,661 profit - but it is unlikely the new owner is going to be able to raise the income to the 'Stabilized' level without spending some money along the way through renovating units or general building maintenance. How much is the question...and this is where good deals are won or lost. 

I had a long post typed out, but I think we have a different idea of how CAP rates are used and there is no use going back and forth on this. It seems like you're implying it's used to evaluate a deal. I'm saying it's used to establish "comps" for a given class of property in a given area/time.

Buying a property at 4.x% CAP when that market says it's 6-7% seems foolish unless a major play could be had to make that up. The numbers you provide show that the buyer will make virtually no money (outside of cashflow difference) by going through the trouble of raising rents, turnovers, etc. I wouldn't do that, but it's JMO.

Dustin, I don't disagree with you, they're certainly used as comparable information, but they're also used when evaluating the deal. Both applications are correct. Regarding your second point, I would argue it is only foolish to someone who isn't planning on owning the building for a long period of time.

 That's somewhat fair to play the long game and ignore the fair market value. Still not a buying philosophy I would get on board with, but agree it makes more sense the longer you keep it (in most time situations where appreciation is inevitable with enough time lapse).

@Dustin Beam I have found that advertised CAP rates are often not accurate. I have seen agents "project" a CAP rate, meaning if you raise rents and get lucky that your cap rate will be X%. I have also seen expenses left out of CAP rate calculations. I have seen this on MLS listings, which blows my mind, but just goes to show the disclaimer at the bottom is there for a reason. Run your own numbers.

CAP rate also doesn't take into account property condition. Maybe you find a 6% CAP rate property and 8% in the same market. The 8% may be a D class property with lots of deferred CAPEX. If you need to replace a roof or boiler, you will see 0$ increase in rents, so you are not increasing value. Like one of my houses currently has a cracked sewer line. I will need to dump $4K into fixing it and the property will not increase in value.

I understand when people buy properties and improve them to increase value. What I don't understand is who buys them after being improved? Once you have fixed management and maxed out rents on an apartment building, the investment just lacks much up side. They often have low CAP rates, so it seems like people just have cash to spend and time to wait.

Originally posted by @Joe Splitrock :

@Dustin Beam I have found that advertised CAP rates are often not accurate. I have seen agents "project" a CAP rate, meaning if you raise rents and get lucky that your cap rate will be X%. I have also seen expenses left out of CAP rate calculations. I have seen this on MLS listings, which blows my mind, but just goes to show the disclaimer at the bottom is there for a reason. Run your own numbers.

CAP rate also doesn't take into account property condition. Maybe you find a 6% CAP rate property and 8% in the same market. The 8% may be a D class property with lots of deferred CAPEX. If you need to replace a roof or boiler, you will see 0$ increase in rents, so you are not increasing value. Like one of my houses currently has a cracked sewer line. I will need to dump $4K into fixing it and the property will not increase in value.

I understand when people buy properties and improve them to increase value. What I don't understand is who buys them after being improved? Once you have fixed management and maxed out rents on an apartment building, the investment just lacks much up side. They often have low CAP rates, so it seems like people just have cash to spend and time to wait.

 Pro formas are garbage lol. No doubt. 

And sure, you can find different CAP rate properties in the same market. But again, CAP rates applied to a specific property don't really make sense. It does not project profit, just like you are saying about a roof or boiler. A whole other separate analysis should be done for that. I would say, for me, if I'm looking at a property w/ deferred maintenance, this is what I'd want to see for the CAP: NOI/[purchase price + price to fix deferred maintenance + what my effort is worth to do that work in dollars] = market CAP rate. In that scenario, I'd be buying at less than market of an average propety, but taking into account the time and effort to fix the deferred maintenance. Basically getting the property at a discount because I SHOULD be getting it at a discount.

Agreed on your last point. I'm not a savvy, experienced commercial investor, but unless the buyer expects appreciation then I don't see why you would ever buy a low cap property that is a well oiled machine. But of course, yesterday I would have not been able to give you any explanation why you would buy a low cap property at all lol. I at least see one way (a mismanaged low cap property) that a good profit could be earned. "Economical Flipping" commercial property in a low CAP area actually makes more sense than a high cap area. Something that never occurred to me until this morning.

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