How to Invest in the Hottest Real Estate Markets and Still Cash Flow

by | BiggerPockets.com

Most people think there are two options when buying rental property. Option A is to buy in a hot market with little to no cash flow and wait for appreciation. If you’ve been listening to the BiggerPockets Podcast for a while, you know this method is frowned upon by most investors here. Option B is to buy in a market with good cash flow, even if you don’t see much appreciation.

But what if there were a third option? What if you could combine cash flow with great appreciation? Well, you can!

Before we get into that third option, let’s talk for a minute about cap rates and why the first two options exist.

A Primer on Cap Rates

A cap rate, short for “capitalization rate,” is the relationship between net operating income (NOI) and purchase price (purchase price divided by NOI). If you have a low cap rate, you’ll pay more for the property and get less cash flow. A high cap rate means you’re paying less for the property and have more cash flow.

Why We Have Two Options

For this discussion, we have to assume investors are rational. We can debate that assumption in the comment section, but for the most part, large institutional investors are rational, and they’re the ones setting prices.

Now, why would someone be willing to pay more for a property and get less cash flow, i.e. low cap rate markets?

If a market has great fundamentals, including population growth, job growth, rent growth and high occupancy, an investor is willing to pay more for income generated by a property than they would in a market that doesn’t have those fundamentals. That’s because there’s future upside that’s not being accounted for in the current income. Let me say that again: Investors are paying more because there’s potential for income growth.  

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Related: Cash Flow vs. Equity: Which Pays Off for Investors in the Long Run?

So, if you see a low cap rate, that means people are paying more for the same income, and it’s likely that this market has good fundamentals. Markets where people are moving to in large numbers (think Phoenix, Seattle, Austin, and Charlotte) have low cap rates. Conversely, in high cap rate markets where investors are paying less for that income, the market likely doesn’t have great fundamentals. Josh Dorkin would probably give an example of Detroit here.  

You Can Have Both!

Now, here’s where value-add comes in. What if you could buy in a low cap rate market—so somewhere with strong fundamentals and a high likelihood of appreciation—but still get cash flow? Ben Leybovich and I just did exactly that on a recent deal here in Phoenix.

Phoenix has great fundamentals. It’s number two in the country in population growth amongst large cities. Rent growth for 2018 is near 7%. Phoenix is adding jobs twice as fast as the national average. So, it should come as no surprise to you that Phoenix has cap rates under 5%. We just bought a 98-unit apartment at a 4.75% cap rate. That probably sounds crazy to some of you, but I can assure you we’re excited about it! Why? Because after our $1.4 million renovation, we’ll be able to increase rents by over $300. That will bring our cap rate to over 8%! What’s more, we’ll still get the benefit of being in Phoenix, and all of the potential upside that comes with it. As the population continues to grow, we continue to add jobs, and rents get even higher.

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Related: My Secret to Maximizing Cash Flow & Appreciation: Buying on the Fringe

That delta we create in the cap rate (sub 5% to over 8%) through value-add projects is what allows us to buy in a hot market and still get cash flow. Now, as this method gets more popular, that delta will continue to shrink. Some of the big value-add investors in Phoenix last year have already moved on to places like San Antonio because of competition. It might take longer to find a property with that large of a delta in Phoenix, but if you can find it in the hottest markets, i.e. great fundamentals, the payoff can be huge.

Another reason a value-add deal can be more rewarding in a hot market than a mediocre market is the amplification of your increased income. If I’m in a market with a 10% cap rate and I increase income by $100,000, the value of my property increases by $1,000,000. However, If my market is at a 5% cap rate and I increase my income by the same $100,000, the value of my property has now increased by $2,000,000! The lower the cap rate, the greater the amplification of your value-add project.

We’ve been told for years that it’s all about cash flow. Appreciation plays are too risky. Well, I’m here to say it’s about creating cash flow in a market that will give you plenty of upside and appreciation. You can have your cake and eat it, too.

Do you invest primarily for cash flow, appreciation—or some combination of both?

Weigh in with a comment!

About Author

Sam Grooms

Sam Grooms is Managing Partner of WhiteHaven Capital, a multifamily investment firm specializing in value-add properties. Sam began his career at Deloitte, where he assisted public companies with their SEC filings. He went on to manage the SEC reporting for Amkor, a $3 billion public company. Sam graduated summa cum laude from Arizona State University with a bachelor’s and master’s degree in Accounting, and is a Certified Public Accountant.

6 Comments

  1. Ryan Wilson

    Buying based on future rent increases, population and job growth may work out for you or it may not. We soon forget how quickly the economy can change, companies can stop hiring, interest rates can spike, rents can stagnate or even decline. Look at the “unexpected” spike in interest rates that just happened and the 800+ point single day drop on the DJIA.

    Buying at such low cap rates forces someone to rely too much on everything “working out.” What if you can’t raise rents $300 because the economy slips into recession within the next 1-3 years? What happens if interest rates spike again and now your debt service is much higher?

    I understand that if you look at all of the negative potential outcomes, someone may never start investing and that is not good either. However, it’s all about margin of safety and stress testing negative outcomes to see how your asset would perform under such situations. Given the length and strength of the bull market in both equities and real estate, I think prudent investors should pay close attention to their margin of safety if this bull market decides to take a breather. Especially multi-family investors. 4% doesn’t leave much of a margin of safety for most prudent investors.

    I hope your investment works out great and the economy, jobs, interest rates, and real estate values continue as they have for the past 5+ years. That may very well be the case!

    “Be fearful when others are greedy and greedy when others are fearful.”- Warren Buffet

    • Sam Grooms

      Ryan, thanks for the comment. I agree that you shouldn’t buy just based on trends. Those are icing on the cake.

      As for the potential of not getting the $300 increase in rents due to a recession, that’s the same risk for everyone, whether or not you have a value add project. Either way, we’re finishing our renovation in 12 months, and we’ll have “bought” at an 8 cap in a hot market. That’s a very conservative cap rate for a market like Phoenix. If the market took a dive, and I had to sell it for a discount, that discount likely won’t be at anything higher than an 8 cap, so capital would be preserved.

      People have been saying for 4 years that they want to wait on the sidelines because the end is nigh. Do you know how much money was made in the last 4 years? And the economy is only stronger than 4 years ago. The only concern I see is the yield curve. Everything else is still showing growth.

      If you can buy at an 8 cap, get into fixed rate debt, and be well capitalized, you can withstand a downturn. That limits your risk and you still have plenty of upside. Sign me up for that.

  2. Ali Rashi

    Sam, great article. I am currently facing this dilemma And can relate to it. With me there it is a constant battle between cash flow and appreciation and I want them both every time I can get them.
    I like your approach and will be applying it to my next investment but do you think this strategy would work as effectively on SFR or smaller multi units?

  3. James McCreary

    I learned a new perspective from you Sam, there is actually a positive to a low cap rate on the buy side, who would have thought =)!

    @Ken Breeze and I are in Phoenix and it is a market beast of its own. Cap rates are somewhat indicative of investor sentiment but its heartening to hear of your optimism on the subject. When the flurry of real estate takes the reins of investors’ minds, we must keep our wits about us!

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