What is a good cap rate for apartments? Are they really better than SF and small Multis?

Question

I am fairly new to investing, but want to grow aggressively and have been considering taking cash I have and investing in an apartment building (currently looking at 6-10 units).

I've done a lot of digging on the site and listen to the podcasts. I keep seeing/hearing the number "10% cap rates" come up, but I've yet to find a definitive answer on what is considered "good" when it comes to apartment buildings and what I should aim for when buying.

I have a few duplexes and single families and get great cash flow on them (which is what I personally want and care about) and they are all at 10-15% cap rates in A to B- neighborhoods (just selling on the regular ol' MLS) and don't really require a lot of upkeep, maintenance, etc and rent easily. I am familiar with the pros and cons of buying a small MF vs SF and large apartments, but even still, why would I pay a huge amount of money down to get a smaller cap rate of 10% when I can find much better cap rates elsewhere?

I ask because it seems to me that the average trajectory of an investor is to start off with smaller properties and eventually buy bigger ones, but these numbers don't really seem like growth to me. Again, I'm newer to investing, but is the economy of scale and ease of one building really worth it? In my case and market (Rochester, NY), should I be aiming for higher cap rate buildings?

Let me know your thoughts.

Brian Burke · Answer

Shannon, forget about aiming for a cap rate. This is a mistake that new investors make when trying to get into the Multifamily space. Then they wonder why they never find a deal and then declare that the other buyers are crazy because they are paying way too much because they bought at X cap rate and not at 10%. You see, cap rate isn't about you. It's about the market and what buyers in the market are willing to pay. You can't buy a property at a 10% cap rate in a market that is trading at a 6 cap.  Unless, of course, you find a deal that no one else is looking at and is owned by a seller that has no idea what they're doing...or if YOU think it's a 10 cap when it really isn't because you are calculating the NOI improperly.  BTW, the second example is more common than the first.

So instead of trying to control that which you cannot, use cap rate properly and thus to your advantage.  Cap rate should be used to calculate your exit, not your acquisition.  To do this, first you must forecast what the income will be every year of your hold period. Next you will use whatever the prevailing market cap rate is to calculate the property's value each year. Now you can calculate the IRR of the deal using the cash flows from the sale (in whichever year you choose) and from the cash flow during the hold period and determine if the rate of return is acceptable to you. The IRR is the measure of the quality of the deal, not cap rate.

Don't believe me?  Here are two pieces of evidence:  1. if you increase the NOI by $10,000 you increase the resale value of a 10 cap deal by $100,000 but a 6 cap deal goes up $166,667.  2. If rent growth is forecast to be 1% in a 10 cap market but 5% in a 6 cap market, from which deal will you collect more total cash during the lifecycle of the deal?

Winning the game means picking the investment alternative that pays the most in total.  Cap rate alone will not tell you the answer to the game-winning question.  It is a lot more complicated than that. Finally...there are trade-offs to be made in order to conform your investment to your goals. Some people buy stocks that pay high dividends but have little chance of trading much higher (or even buy bonds) while other investors buy growth stocks that pay no dividends but have a great chance of appreciating exponentially. Such is the relationship between cash on cash return and IRR, so you have to find the combination that works best for you and fits with your strategy.

John Thedford · Answer

@Shannon Sadik

get the book by Frank Gallinelli called "what every real estate investor needs to know about cash flow". His book defines dozens of different ways to measure the financial aspects of a RE deal. It explains IRR, cap rates, NOI, present value of future dollars, and lots more. It provides formulas to calculate all of them. It is an excellent source of information and one every investor should have in their library.

Austin Youmans · Answer

You can get about the same cap rate  but it is harder to find as there are fewer apartment complexes than houses.

But the real advantage is time and acquisition.

How long would it take you to buy 25 houses with 25 different loans?

How long would it take you to buy 1 apartment building with 25 units under 1 loan?

As you have more loans banks don't want to loan to you so you have to find other financing. but if you move to apartments it is easier and faster to acquire one loan for 25 units than 25 loans for 25 houses.

Also The cap rate on larger apartment complexes include a full time employee usually to take care off all the day to day work which saves you time and money driving around all the different properties.

Randy Haller · Answer

@Shannon Sadik

Cap Rates are relative to the value of the property, just like the total prices on smaller properties.  The more valuable and desirable the apartments are...the lower the cap rate would likely be.  Inversely, on a smaller multifamily...the better the property, the higher the price.

Would you rather pay a higher price for a 2 family in good condition in a good area, or a dirt cheap price for a run down double in an undesirable area.  Same concept.

A great property with low cap rate may be a fantastic deal (especially if there is an upside), and a high cap rate property may have problems that are not worth solving.   Of course, this factor just looks at the numbers...and only if the bottom line is calculated correctly.  There are also many other items to consider besides the cap rate.  Number of units, location, quality of tenants, condition of mechanicals, financing alternatives, management and maintenance choices, etc.  These issues may even be more important to a buyer than the cap rate.  In a tight market like Rochester, demand for larger multifamily properties makes correctly analyzing them even more critical.

I'll take a quality property in a good area with a low cap rate any day of the week...especially if there is an upside or the seller is easy to work with.

Anthony Gayden · Answer

I think the greatest benefit to commercial real estate is the forced appreciation aspect. Imagine that you are like the majority of people and don't live in San Francisco, NYC, or other highly appreciating areas. You can still experience the benefits of appreciation by lowering costs and increasing income in a commercial property. You can then either sell or refinance that property to get money out of the deal for reinvestment. This works whether your property is located in the middle of the hood in Detroit, or in a tiny rural town in Montana.

Austin Youmans · Answer

@Shannon Sadik  - Can't get your name to link for some reason...

That is my strategy. Start with residential loans as it is cheaper to get started and then move into commercial loans. At the point where residential loans become harder to get I will do a 1031 exchanged into a apartment complex.

Ken P. · Answer

It depends on where you're going and the speed you want to get there.  Michael Blank and some of the  podcast guests, such as Serge Shukhat in the most current podcast #131, have said it better than I ever could - forced appreciation (value add) is possible in larger apartment properties in ways that are impossible in single family rentals.

With SFRs, the value of your holdings is determined by the values of comparable properties.  With apartment buildings, the value is determined by the cap rate for similar class of building, and the NOI of your building.  Anything that you do to increase the net operating income increases the value of the building, which increases your equity, benefiting you when you refinance or sell.

Brie Schmidt · Answer

@Shannon Sadik

I have found the same thing in my market.  I have looked at 25+ unit buildings but the overall rate of return is greater for the smaller buildings, so I buy 2-4 unit properties.

Hersh M. · Answer

@Shannon Sadik

+1 on Frank's Cash Flow book. Thats where I first learned about these different ways of evaluation. There is a lot more math involved than I first assumed.

Shannon Sadik · Answer

Thanks everyone! That helps clarify things a bit for me!

What is a good cap rate for apartments? Are they really better than SF and small Multis?

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