All Forum Posts by: Sam Grooms

That's understandable. The more you learn and more sophisticated you get, you'll start to calculate your offer price based on the cash flows and cash on cash returns, and not on a cap rate. 

Here's a scenario for you: Say you keep making offers at the average submarket cap rate, 7.5%. However, none of them ever get accepted. You see the eventual closing price, and notice that you keep getting outbid by someone willing to pay 7.0%. Would you be willing to pay 6.9% and start getting those properties, or stick to your guns at 7.5%? Would your answer change if you were able to get a lower interest rate than that guy? 

What if interest rates dropped 50 basis points in 2 months (like they just did)? I can now pay a lower cap rate for the same cash on cash return. If I underwrite to a return, I can take advantage of that interest rate decrease. If I underwrite to a cap rate, I have to wait 6-12 months for other people's transactions to show up on a report, and see that cap rates have decreased as a result of that lower interest rate. But by then, the interest rates might have changed again, and I'm still left out. Or worse, interest rates went back up, so the people who underwrite to cash on cash won't pay as much, but you see their cap rates from 6 months ago and think that's where the market is, so you overpay. 

Cap rates are an output, not an input. Learn to calculate your offer price based on your return requirements (10% cash on cash, 15% IRR over 10 years, etc), and you'll be better off.

Cap rates are an output, not an input. 

Once you get down into the smaller unit count, price per unit/door will usually be the driver for price, which appears to be the case in this property. As you move up into larger multifamily, prices will be based on returns. This takes into account the type of financing I can get. What's my cost of capital, both equity and debt. This has a huge affect on how much I can pay for a property, but isn't accounted for in a cap rate. 

Also, in a hot market (which is most markets at the moment), future value-add can get priced in to the property. In Phoenix, stabilized properties go for around a 5%. However, value-add can get down to the low 4's. This could be for identical properties, just one has better management. You're paying a premium, because the seller's broker knows you'll be able to bring up the NOI. But people are willing to do it because maybe the value-add is bringing my cap rate all the way up to 8%. So sure, you're giving the seller some of your upside, but if the alternative is waiting years for cap rates to go up, you might be waiting a while. Better to have a slightly smaller piece of a large pie, than no pie at all.

All of this to say, most people aren't buying on cap rates, whether you're looking at small or large multifamily. There's so much more that goes into it. 

Exactly. Expenses aren't some magical percentage. If my rents jumped from $500 to $800, it's not like all of my expenses follow suit. Only use a "rule" for preliminary underwriting, to weed out deals and determine if further underwriting is warranted. 

I would never underwrite expenses lower than the averages. I buy 80's product, individually metered, individual hot water, individual HVAC. My only variance is between flat or pitched roof. I know that for my type of product, in my market (Phoenix), operating expenses are going to be $4,200-$4,300 per unit per year. Someone might have lower rents, so the 50% rule makes it seem like they have enough expenses, but when you look further, they're running it extremely lean at $3,400/unit/year. That's not sustainable, so I'll need to increase them, even if that means I'm up to 65% of gross income. I also know that anything under 9% economic loss (physical vacancy, loss to lease, bad debt, concessions, non rev units, etc) in my market isn't sustainable. Sure, they might be running at 5-6% right now, but that's because there's virtually no physical vacancy right now. Eventually, supply will catch up to demand, and occupancy will normalize. 

In the end, how most people are taught to buy, based on the 1% rule, 50% rule, cap rates etc, can get you into a lot of trouble. Those are all outputs, not inputs, and can be highly manipulated. They're OK to use as a filter, but then you need to actually underwrite a property to your required returns. You can then calculate your outputs (expense ratio, cap rate, etc), to see where you land compared to the market. 

 Yes, just discuss with your lender first. They limit how much of a credit you can receive at closing. 

At a high level, the numbers appear to work. Implied NOI of $37,500. You'll want to verify the numbers they're giving you, but next you'll want to look at your return. Let's assume you put down 25%. Interest rates have dropped quite a bit over the last month, we'll assume 5% for this, with 30 yr amortization. Mortgage of $18K/year, plus lender capex reserves of $3K/year. Assume $15K of closing costs, and your cash on cash would be about 15%. That's assuming there wasn't any deferred maintenance needed on the property, but the lender almost always have some required repairs after their inspections. I also only used $250/unit/year for lender capex reserves, it might be $350+, but that only drops your cash on cash down to 14%.

I clicked on this thinking you were inviting people that are doing deals to come to your dinner. Is this just for potential investors?

That's why at least half of the multifamily buyers in Phoenix are from California. @Ben Leybovich and I were at a meeting last year, and the Governor of Arizona, Doug Ducey, was speaking. He said something along the lines of: "The best thing to happen to the Phoenix economy was California electing Jerry Brown." Personally, I love what California is doing. We have some multifamily buildings we can sell them. 

If you're deciding whether or not to analyze a deal, a 50% rule (or similar) is OK to use. But once you decide to analyze a deal, you need to underwrite using actual dollars and actual percentages (for property management). Using rules like this in large multifamily can lead you in to bad deals, and/or keep you from buying good deals. 

I haven't received my 2018 K-1s for any investments through RealtyShares. They're with different sponsors, so my guess is that it's not something at the sponsor level. RS likely has the K-1s from the partnerships, and just hasn't produced K-1s at the RS investor level. 

Greg nailed it. Investors don't mind that you're getting paid. They need you motivated and incentivized to complete your business plan. They really only question you when your interests aren't aligned.