CAP RATE question -- isn't higher better as a buyer?

Question

When considering buying a 10-unit apartment complex, is it better to buy below the average cap rate for the market, or above the cap rate for the given market?

For example, there is a property I am looking at as follows:

Hardly ever any vacancy, strong rental history (confirmed), rent roll confirmed (possible ability to raise some rents), expenses confirmed, no major CapEx / repairs needed soon.

NOI: $50k

Cost: $500k

Cap rate 10%

Local average is 7% cap rate for B- / C+ apartment complex.

What I don't understand is this --> this property will cash flow well, seems to be a great investment, yet is considered a "risky" investment compared to the market Cap rate average given that it is 10% versus 7%. I can even likely increase the NOI which will increase the Cap rate more. Yet people are telling me this too high of a cap rate and I should be hesitant. I don't understand it, can someone help...

Taylor L. · Answer

I think Cap Rate is massively overrated as a metric. Cap rate alone doesn't tell you what return you're expecting to get, other metrics like cash on cash return and IRR do that. They will also incorporate all of your repair and transaction costs. It also doesn't give the best comparison to other transactions in the market, information like $/door and $/sq ft are also highly relevant.

There's probably a reason why the market says this particular property should be 10% when comparable properties in your market are at 7%. Generally speaking, hairier properties sell at higher cap rates. Is this property in a less desirable area?

I'm not aware of anyone who expects interest rates to go up to any appreciable degree in the near or not-so-near future. The Fed has openly stated that they're keeping their rates low for the next few years. Commercial real estate debt is priced off of the 10-year T bill, and those are also at incredible lows.

Immanuel Sibero · Answer

@Ryan Logue

I think you're looking into "cap rate" a little too much :-) I would focus less on cap rate.

"..is it better to buy below the average cap rate for the market, or above the cap rate for the given market?"This one is easy. I'm assuming everything is held constant, all numbers are verified, the properties are the same quality, in the same quality market. When you buy below market cap rate you pay more than asking price. If there is good reason for this then the price you pay is the new market price for that property (i.e. you set a new cap rate). When you buy above market cap rate you pay less than asking price. A good reason for this could be you just got yourself a good deal or it's a declining market.

"I can even likely increase the NOI which will increase the Cap rate more. Yet people are telling me this too high of a cap rate and I should be hesitant. I don't understand it, can someone help..."

You should abandon this concept of making money by purchasing a property and “increasing cap rate”. As you stated, increasing NOI will increase cap rate but then people say “too high a cap rate” is a bad thing. Hmmm… seems contradictory, isn’t it? If you buy at 10CAP and pull out your tricks and increase cap rate to 15CAP, I’m guessing people would say it’s a good thing, right? But what if you were able to increase cap rate to 25CAP? Would people say it’s a bad thing because it’s “too high a cap rate”? Where is the threshold where you go from good to bad? 19CAP? 21CAP? What’s the formula to determine “too high a cap rate”?

This is the reason you should forget the concept of “increasing your cap rate”. You already have the answer. You purchase a property and make it your goal to increase NOI. The higher the NOI the higher the value of the property. Who cares what cap rate does. No one is going to complain about your NOI being too high (i.e. “too high an NOI”).

"On the flip side, with interest rates so low, does this also mean there is a risk for the value to decrease a bit if rates rise significantly. For example, if this $500k purchase price goes down to $475 market value with increased interest rates, then the cap rate increases and the investment was a poor choice."

Although they’re not strongly correlated, there is enough data to show that cap rate tracks the movement of interest rate (some say cap rate tracks the movement of 10-year TBill yield which influences interest rates in general). In turn, interest rates movements directly affect investors’ required ROR (i.e. rate or return) in that higher interest rates lead to increases in investors’ required rate of return and therefore drive down valuation of asset in general (including real estate). So I agree that should rates rise real estate values would trend down. At least this is the theory in general but know that we’re dealing with real estate where everything is local so there are of exceptions.

Your example of $500k at purchase and $475 current value (i.e. buying at lower cap rate) is not necessarily a poor choice. It’s not a poor choice if it was planned from the beginning. In the current environment of low interest rates and low cap rates, many conservative investors build into their underwriting to buy at lower cap and sell at higher cap. And, yep they still make money.

I also agree with another poster that there is something more about a property for sale at 10CAP when the prevailing market is at 7CAP. WHY would anyone sell below market when he can easily get market rate? Is he ignorant? Is he generous? Or maybe there is something about the property you do not know about?

Cheers... Immanuel

Austin Andrews · Answer

Cap rates are usually driven by the area. If you can buy a 10% cap rate in a 7% area, I would jump on it. If you purchase and raise the NOI, which raises your cap rate at your purchase price, then calculate backwards what it is worth at a 7% cap rate, you just made quite a profit.

Just think, if you buy this property, could you resell it at a 7% cap rate?

Steve Morris · Answer

"this property will cash flow well, seems to be a great investment, yet is considered a "risky" investment compared to the market Cap rate average given that it is 10% versus 7%. "

More likely - They probably calculated CapRate differently and made a lot of positive assumptions on a hard to sell property.

This is why CApRate sucks - Reporting bias.  If EVERYONE uses REAL RECENT operating numbers great - Then you have broker ProFormas which for the most part 20% off or worse.

Sami Gren · Answer

Good point, I don't understand $/door there's a huge difference if the door is a studio apartment or a 3-4 bedroom apt. It can.be easily an $800 difference....

Austin Andrews · Answer

Usually the debt service is calculated after the NOI, so it technically shouldn't affect it. The main thing with interest rates being low is people can afford to buy bigger, and are more opt to.

For example, I calculate NOI at 50k, debt service at 10k, NOI after debt service is then 40k. We use the original NOI to calculate the cap rates.

Ryan Logue · Answer

Thank you for the reply.

On the flip side, with interest rates so low, does this also mean there is a risk for the value to decrease a bit if rates rise significantly. For example, if this $500k purchase price goes down to $475 market value with increased interest rates, then the cap rate increases and the investment was a poor choice.

I'm just trying to see if my rationale is correct here, as I usually stick to SFH / duplex and use CoCROI as my metric.