It's not possible to get a decent ROI with a cap rate <10%

Multi-Family and Apartment Investing
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It's not possible to get a decent ROI with a cap rate <10%

Nick Rose
Investor · Ann Arbor, MI · Member since 2016 · 23 posts · 7 votes

Ok, I suppose it is possible - I'm just hoping to get some experienced investors' take! I do have capital that I'd like to put to use in an apartment building in the roughly 400K-700K range, however I can't seem to make the numbers give me a decent ROI. This very well may be mission impossible. I've run some numbers on several market rate deals, and below is roughly what I've seen:

Purchase price - 700K

Cap rate = 8%

NOI = 56K

I'd need a loan and property management.

Property management ~7800/year

Loan (5%, 20 year amort, 20% down) = 44.3K/year

Cash flow = 56,000-7800-44,300 = $3,900/year

This assumes NO capital expenses and assumes the current owner's maintenance numbers are spot on.  

How is everyone making this work for them? Perhaps others are finding 11%+ cap rates in good areas? 

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Jeff Greenberg
Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
9y

In this market we are in, it is difficult to find stabilized deals that make sense. The beauty of CRE is to be able to add value to a property. Putting capital in to increase your noi, increases the value. It will take time to get the ROI just from cash flow. You can cash out refi, or sell to access the equity that you have created.

In this strong MF market, we only buy value add opportunities.

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  • Kim Meredith HamptonBusiness Member
    Real Estate Broker · St Petersburg · Member since 2014 · 2k+ posts · 2k+ votes
    9y

    @Nick Rose mistbifnthebdeals ive seen lately on MF, cap rates are around 5-7%, I usually don't see anything at 10% unless it's in a C area and there is room for value add, which equals money in cap X 

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    9y

    In this market we are in, it is difficult to find stabilized deals that make sense. The beauty of CRE is to be able to add value to a property. Putting capital in to increase your noi, increases the value. It will take time to get the ROI just from cash flow. You can cash out refi, or sell to access the equity that you have created.

    In this strong MF market, we only buy value add opportunities.

    5Reply
  • Austin Fruechting
    Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes
    9y

    If that is a true 8cap, that NOI would already have property management fee accounted for.

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  • Nick Rose
    OP
    Investor · Ann Arbor, MI · Member since 2016 · 23 posts · 7 votes
    9y

    @Kim Meredith Hampton  I agree with you that in order to find properties that are not in high risk areas, 5-7 caps are typical.  I was aggressive in my above example.  How is anyone making any money with multis?  Are they self managing and all cash?  With all cash the Roi would be so low, why bother?

    1Reply
  • Kim Meredith HamptonBusiness Member
    Real Estate Broker · St Petersburg · Member since 2014 · 2k+ posts · 2k+ votes
    9y

    @Nick Rose Most likely for appreciation, and the sale on the backside. If its vale add, there is always the potential in the short term to sale or refi to pick up other properties.

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  • Michael Le
    Developer · Houston, TX · Member since 2015 · 1k+ posts · 1k+ votes
    9y

    As @Austin Fruechting mentioned, you're using an NOI number that should already include all expenses such as property management, and then you're adding property management again on top of that. You're double counting an expense. Are you okay with the returns if you remove that $7800?

    1Reply
  • Mike Landry
    Investor · Montgomery, TX · Member since 2014 · 386 posts · 151 votes
    9y

    i think in your example your true cap rate is much lower than 8. As mentioned above cap rate should include property management expenses. Maybe even capital expense allowances? Not sure about that one though. 

    This is why I think the market is due for a correction. People are paying too much for properties and self managing to get a %10 return on their cash.  Or taking on the JOB of stabilizing a distressed property to get a %15 return.  No thanks. Not worth my time or money. But I'm keeping an eye on the market for when it does make sense to me personally. Those people that bought at those high caps will be in trouble when their loan is up or if they can't maintain their dscr. If they paid cash or put a significant amount down they'll be ok, but what an inefficient use of capital if you ask me. 

    1Reply
  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    9y

    I haven't seen or bought a true 10 cap since 2005 outside of rehab only, non-habitable ghetto apts you have to pro forma.

    The key is to know your market cap and scoop up what is above that with arbitrage. Find an off-market owner that doesn't know what the market cap is or is distressed and doesn't care.

    In my 2 markets, the current market cap is 6.5 and 7.5   When I started buying them in 2002, they were 9.5 and 10.5   2 of my sellers in the 10.5 (then) market were distressed (a bank facing a 3rd qtr balance sheet problem + a mom & pop out of area with sick wife) so I got them for a 13 & 14 cap.  What is the market cap for your area and asset class @Nick Rose?

    I have a hard time getting excited about anything less than 8.  While others may accept that return, it doesn't mean I have to.  I can earn that easier in paper securities with a lot less hassle.

    Arbitrage and value-adds are the way to go.  When caps compress 1% more in my area, I'm selling and exchanging to a new market entirely.  I'm timing sales more than fighting to buy skinny returns.  Good luck! 

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  • Michael Le
    Developer · Houston, TX · Member since 2015 · 1k+ posts · 1k+ votes
    9y

    @Mike Landry, technically the replacement reserves are below the line and not part of the NOI calculation, but your lender will count it as part of the DSCR calculation so I include it above the line anyway.

    Also, I think you meant that 'people that bought at those low caps will be in trouble'.

    1Reply
  • Bill Gulley
    Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    9y

    Good comments above, my CRE experience is more about what it can be, not what it is and the ROI is upon the exit, not holding it.

    Be careful buying based on CAP rates, usually you're wrong and you won't know until time passes and never use the seller's rate, it won't be the same for you. You're guessing, look at cash on cash short term. Leverage the deal and let others pay the tab. Good luck :)

    2Reply
  • Nick Rose
    OP
    Investor · Ann Arbor, MI · Member since 2016 · 23 posts · 7 votes
    9y

    @Mike Landry @Austin Fruechting

    I've seen capex calculated both ways- some include property management, others omit it. Good point though, so If I assume best case and include management costs, and put in a more realistic cap rate of 6% - I calculate a net loss of -$2300/year. -1.68% ROI. This assumes a CRE 20% loan. This would be for a stabilized property.

    Obviously, and value add property would look different.  Naturally, even the value adds are going for more and more.   Likely due to the low cap rates on stabilized market.   

    @Mike Landry

    Agreed - time and effort (and money) are precious and limited for many of us. I've been trying to find the best use of money time and money, and have been disappointed in what I find in CRE. I may have to continue with smaller 3-4 units. It's slow and will require closing on quite a few deals.(time)

    *sigh*

    2Reply
  • Austin Fruechting
    Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes
    9y

    Yep, pro-formas will almost always leave out some expenses and paint the rosiest possible picture they can. I always assume if I see something listed at an 8cap, in actuality its a 6cap just as you pointed out there.  The TRUE cap rate would be after all expenses including cap-ex.  

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  • Account Closed
    Professional · Brooklyn, NY · Member since 2017 · 624 posts · 147 votes
    9y
    Originally posted by @Nick Rose:
    ...How is everyone making this work for them? Perhaps others are finding 11%+ cap rates in good areas? ...

    Which markets are you looking into? The cap rate doesn't usually reflect the rate of attainable yearly price growth in the value of the rental property which often explains why a rational investor may often invest in some lower cap rentals.

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    9y

    @Austin Fruechting 99% of the time I see capex below the line and not included in the cap rate.  @Nick Rose I have never seen management below the line and not in the cap rate.  I have however see the management missing all together, which doesn't give you a true cap rate.

    1Reply
  • Austin Fruechting
    Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes
    9y
    Originally posted by @Jeff Greenberg:

    @Austin Fruechting 99% of the time I see capex below the line and not included in the cap rate.  @Nick Rose I have never seen management below the line and not in the cap rate.  I have however see the management missing all together, which doesn't give you a true cap rate.

    Interesting. In my area that's all included, as it should be, because otherwise you aren't looking at actual NOI, and therefore not looking at a true cap rate. The only CapEx that wouldn't show is if someone did a major value add rehab. Other than that CapEx is an expense that should be a part of calculating the NOI

    ***albeit all expenses are generally underestimated to make it look better. 

    Edit to add, by your market putting CapEx below NOI they are trying to sucker in unsophisticated or new buyers that take the pro-forma at its word. Bravo for actually digging in and doing your homework to not get taken in that.

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    9y

    @Austin Fruechting I understand the logic of putting the annual capex reserve in with the operating expenses, but major cap ex or one time expenses would greatly skew the cap rate and the overall performance of the property.  Logic or not, the industry standard is to put it below the line.  The important thing to know is where they put it when you are given it.  With that said, as I look at value add deals, the cap is less and less important.

    3Reply
  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    9y

    Nick why are you using a 20 year amortization schedule? Those suck. Find another lender if that is all you are getting quoted.

    I would rather have a 30 amortization with little to no pre-pay and hold more in reserves. Keep payments low as possible and options open. At least have a 25 amortization.

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  • Stephen Masek
    Investor · Mission Viejo, CA · Member since 2012 · 627 posts · 204 votes
    9y

    Why not buy single family houses which are appreciating with cash?  That way you have cash flow and appreciation, and reduced risk. 

    In southern California, there are deals with very low single digit cap rates advertised, and the true rate is even lower.....    

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  • Austin Fruechting
    Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes
    9y
    Originally posted by @Jeff Greenberg:

    @Austin Fruechting I understand the logic of putting the annual capex reserve in with the operating expenses, but major cap ex or one time expenses would greatly skew the cap rate and the overall performance of the property.  Logic or not, the industry standard is to put it below the line.  The important thing to know is where they put it when you are given it.  With that said, as I look at value add deals, the cap is less and less important.

    Ok.  Perhaps industry standard on the stuff you're looking at.  It's not industry standard to have it below the line on the stuff I have looked at, unless it's denoting a recent major renovation.  A 20-25 unit apartment building will average 1 HVAC replacement a year, that's not just a one time large thing. 

    And I disagree with a major capex expense like a roof on a 25 unit building greatly skewing the cap rate, unless you are looking at a single years P&L then of course it does. The CapEx number for calculating a true cap rate should represent the long term average of all CapEx expenses. So the CapEx account should be 1/30th of the roof costs, 1 HVAC per year, etc etc.

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  • Jeff Greenberg
    Real Estate Consultant · Camarillo, CA · Member since 2010 · 2k+ posts · 1k+ votes
    9y

    @Austin Fruechting Sorry that I will have to disagree. How does an offering cap rate reflect more than a moment in time. That moment is usually 12 months. That is the problem with having cap ex in the cap rate calculation. One roof replacement on 12T P&L is going to look a lot different than a 12t without the roof replacement. The whole concept of the cap rate is to be able to value and compare a property (or business) based on it's income and operating expenses. For example, I start up a business and need to pay a one time expense of 1 mil for equipment that should last 30 years. That 1mil is not going to amortized and have an effect on my cap rate for the next 30 years(it may have an affect on taxes, but that is another story). How are you going to calculate this mythical "true cap rate should represent the long term average of all CapEx expenses" If you want to invent a new term "true cap rate" go for it. The industry standard on all commercial properties uses a 12 month NOI to determine the cap rate.

    Originally posted by @Roy N..:

    @Ed Long

    That's why many of us pay no attention to CAP rates when underwriting a property.

    CAP is only meaningful if calculated on properties which are priced based upon the cash-flow of the business and if calculated in the same manner and on all properties being compared. Even then, it is of marginal benefit when underwriting an acquisition and there are far more pertinent measures which should receive focus.

    2Reply
  • Austin Fruechting
    Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes
    9y
    Originally posted by @Jeff Greenberg:

    @Austin Fruechting Sorry that I will have to disagree. How does an offering cap rate reflect more than a moment in time. That moment is usually 12 months. That is the problem with having cap ex in the cap rate calculation. One roof replacement on 12T P&L is going to look a lot different than a 12t without the roof replacement. The whole concept of the cap rate is to be able to value and compare a property (or business) based on it's income and operating expenses. For example, I start up a business and need to pay a one time expense of 1 mil for equipment that should last 30 years. That 1mil is not going to amortized and have an effect on my cap rate for the next 30 years(it may have an affect on taxes, but that is another story). How are you going to calculate this mythical "true cap rate should represent the long term average of all CapEx expenses" If you want to invent a new term "true cap rate" go for it. The industry standard on all commercial properties uses a 12 month NOI to determine the cap rate.

    ...

    That's why many of us pay no attention to CAP rates when underwriting a property.

    CAP is only meaningful if calculated on properties which are priced based upon the cash-flow of the business and if calculated in the same manner and on all properties being compared. Even then, it is of marginal benefit when underwriting an acquisition and there are far more pertinent measures which should receive focus.

    I think that cap rate and NOI for underwriting should be the long term average of expenses especially since I'm a long term buy & hold guy... and that number will usually look much different than the 12T P&L... so I agree and disagree, LOL. I fully agree with this last paragraph.  This discussion, even if I'm wrong, is of good benefit for anyone looking at investments to realize all sides of analyzing a property and to rely on their own analysis for their goals.

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  • Roy N.Pro Member
    Rental Property Investor · Fredericton, New Brunswick · Member since 2013 · 7k+ posts · 4k+ votes
    9y
    Originally posted by @Austin Fruechting:

    I think that cap rate and NOI for underwriting should be the long term average of expenses especially since I'm a long term buy & hold guy... and that number will usually look much different than the 12T P&L... so I agree and disagree, LOL. I fully agree with this last paragraph.  This discussion, even if I'm wrong, is of good benefit for anyone looking at investments to realize all sides of analyzing a property and to rely on their own analysis for their goals.

    Since you are going through the effort of performing a discounted cash flow analysis out X-periods/years and are a long term buy& hold guy, why not ditch the affliction of CAP - even the lure of trying to calculate a stabilized CAP over a vector of inputs - and look at an internal rate of return {M}IRR or FMMR (pict your preference).

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  • Austin Fruechting
    Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes
    9y
    Originally posted by @Roy N.:
    Originally posted by @Austin Fruechting:

    I think that cap rate and NOI for underwriting should be the long term average of expenses especially since I'm a long term buy & hold guy... and that number will usually look much different than the 12T P&L... so I agree and disagree, LOL. I fully agree with this last paragraph.  This discussion, even if I'm wrong, is of good benefit for anyone looking at investments to realize all sides of analyzing a property and to rely on their own analysis for their goals.

    Since you are going through the effort of performing a discounted cash flow analysis out X-periods/years and are a long term buy& hold guy, why not ditch the affliction of CAP - even the lure of trying to calculate a stabilized CAP over a vector of inputs - and look at an internal rate of return {M}IRR or FMMR (pict your preference).

    My driving factor has always been cash on cash return much more so than CAP, however a CAP based on long term average NOI can provide a quick comparison/benchmark and indicator of cash on cash return.

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  • Eric James
    Investor · Malakoff, TX · Member since 2017 · 2k+ posts · 2k+ votes
    9y

    @Nick Rose. I agree, buying at a <10% cap doesn't make sense, at least for someone in my position. I could see this possibly making sense for someone who has large amounts of capital they need to put into large deals, but not a small timer like me. 

    I could see a short term value add play being worthwhile, but I am hesitant to try that right now due to my inexperience with multis. 

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  • Jeff Kehl
    Rental Property Investor · Charlottesville, VA · Member since 2012 · 1k+ posts · 726 votes
    9y

    @Nick Rose completely agree many people are over-paying for multi-families these days and it just hasn't caught up to them yet. The good news is, if you are patient, you can be there when it does.

    That said I agree that property management should be already deducted before your NOI so I think your example property is profitable and I am actively looking for 8 caps with the exact financing you describe.

    One point you don't consider is the equity paydown on the loan which is substantial. Combine this with the potential for rent increases these days even without the 'value-add' and I will look at an 8 cap for sure. In a growth area? I'm all over it.

    As for the capex debate, that seems to be a huge grey area. Every p/l I look at or broker I talk to seem to have a different opinion. 

    My take is a certain percentage of Total capex should be treated as opex every year. I have seen numbers like $300-500/year/unit and that approximately seems to hold true in my motley portfolio too. 

    The only caveat to that is the first year or two after I buy foreclosure, auction or deferred maintenance property they will have very large capex expenses which I will have to pay as operating expenses.

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