Help a newbie! Cap rates: stabilized vs value add

[Dennis Kwon]

Hey all,

First time poster here! Just started to get my feet wet in the real estate space and I'm reading as much as I can to learn as quickly as I can. I'm interested in being a passive investor (I'm a young doctor who loves his job and has no interest in owning or managing properties at this time). Syndications/funds seem interesting, though I've never invested in real estate before and am brand new to the space.

With that being said, I'm reading through Brian Burke's book - The Hand's Off Investor. In the section discussing Cap Rates, I'm having trouble wrapping my head around why this statement is true: "Cap rates on stabilized properties tend to be higher than cap rates on properties that require value-add"

My internet search and search through BP forums leads me to believe that stabilized properties should have lower cap rates....

Price = NOI / cap rate

If I were buying a Class A stabilized property, I would imagine I (along with the entire real estate market) would be willing to pay a premium price to purchase this property so the cap rate would decrease. On the other hand, if there were a poorly managed property, given the same NOI, I would be willing to pay a much lower price so the market sentiment aka cap rate would go up.

Furthermore, there is this idea of cap rate compression where as you do renovations on properties, the price would go up and you would compress the cap rate. Does this mean if you were to buy a value-add property with an already low cap rate, the cap rate would go even further down? This seems weird to me. 

And why do people always say things like "I turned a 5 cap into an 8 cap property." What the heck does this even mean?

What am I missing here and what concepts am I misunderstanding?

Thanks for all your help!

[Brian Burke]

Originally posted by @Dennis Kwon:

I'm reading through Brian Burke's book - The Hand's Off Investor. In the section discussing Cap Rates, I'm having trouble wrapping my head around why this statement is true: "Cap rates on stabilized properties tend to be higher than cap rates on properties that require value-add"

My internet search and search through BP forums leads me to believe that stabilized properties should have lower cap rates....

The disconnect here is you are attempting to compare apples to oranges: cap rates for a "value add" versus "class A."  This is kind of like saying "which is faster, an airplane or an aircraft."  An airplane is an aircraft, but an aircraft doesn't have to be an airplane, it could be a helicopter, glider, or balloon, too.  Same goes here.  A "class A" could be a value add.  Or not.  And a value add could be a class A.  Or not.

Instead, let's compare like for like:  

Deal #1: A class A that is fully stabilized and rents are roughly equivalent to the comps (meaning there's no value-add potential here), versus

Deal #2: a class A that isn't as well amenitized as it's peers, the management is disorganized and hasn't kept up with rent increases, the interiors, while nice and certainly up to class A standards, lack some basics like stainless steel appliances (it has white) and a nice tile backsplash in the kitchen.

Clearly they are both class A, and clearly deal #1 is NOT a value add.  Deal #2 is a value add--by changing out the appliances, adding a tile backsplash, improving the gym, adding a dog park, upgrading the signage, and putting professional management in place that has its eye on the ball, the new ownership can achieve significantly higher rents than the property is currently getting.  No higher than deal #1, but equal to it.

Now let's examine the purchase. Deal #1 has NOI of $1,000,000 and is selling at a 4% cap rate, so a price of $25 million. Deal #2 has NOI of $750,000 and is selling at a 3.5% cap rate, so we'll call that $21.5 million. YES...see here that the value add deal is a LOWER cap rate?! Now, let's work beyond the purchase to see why.

Deal #1's year 2 NOI is still $1,000,000 because rents were at top of market and there was really nowhere else to go. Deal #2's year 2 NOI is $1,000,000 because the new owner made the improvements and changes listed above (we're talking theory here, it probably takes 2-3 years to do this but doesn't change the logic behind the concept). Let's say it cost them $1 million to do all of that.

Now let's examine where both owners are.  Deal #1 has $1M of income for $25M, giving a yield on cost of 4% (for simplicity I'm not adding in closing and financing costs because they'll be roughly the same for both and overcomplicates an already complicated discussion).  Deal #2 has $1M of income for $22.5M ($21.5M purchase plus $1M improvements) for a yield on cost of 4.44%.  So who came out on top?  Yes, deal #2, despite paying a lower cap rate for a value-add property.  Same income, lower basis, and higher yield on cost, despite lower cap rate.

The answer to why value add trades at a lower cap rate than stabilized deals is because buyers are willing to pay a premium for an income stream that they can grow.

You aren't compressing the cap rate as you renovate.  Instead, you are growing the income.  Another mistake here is that people incorrectly think they control the cap rate.  They do not...cap rate is a measure of market sentiment only.  I always assume that when I buy a value-add deal the cap rate would go UP.  Take the examples above.  If you were to sell both deal #1 and deal #2 above, deal #1 sells at a 4% cap rate (we're assuming the overall market sentiment hasn't changed since you bought the property), and gets a $25M price.  Deal #2 also sells at a 4% cap rate (because that's what the market cap rate happens to be for stabilized assets and now that you fixed up deal #2 it's now a stabilized property).  You bought deal #2 at a 3.5% cap rate, so the cap rate went UP by 0.5%.  BUT, on deal #1 you lost money after selling for the same price you paid (then paid commissions, etc), but on deal #2 you made money because you are in it for $22.5M and are selling for $25M.  So forget about "moving" cap rates, and just focus on moving the income.

People say this when they don't know what they're talking about.  Read this article, it'll clear this up plus the other incorrect information you commonly read (even in these forums) about cap rate.  https://www.biggerpockets.com/...  If you're really a glutton for punishment and want to dive even further into cap rate, check this one out too.  https://www.biggerpockets.com/...