Investing in low cap rates, how does it make sense?

Question

In the portland metro area, like most areas now, are low cap rates, near 4.5%. Mathematically it doesn't make sense to invest, however I am comfortable in this market and I know it very well. I'd be nervous dumping several hundred thousand dollars into a market in say the midewest that I know nothing about just for a higher cap rate/return. How can I make it work to invest locally with the low cap rates? Value Ad?

Brian Burke · Answer

@Eric Berkner, your confusion lies in your attempt to connect cap rate to investment return.

Cap rate has nothing to do with investment performance. It is simply a thermometer that reads the market temperature. When the market is hot, cap rates are low because buyers are willing to pay a premium for an income stream, typically on the belief that the income stream they are buying will be larger tomorrow than it is today. If the market is soft, cap rates go up because buyers aren't willing to pay as much for the income stream, usually because they think that the income stream isn't going to go up much, if at all, or might even go down.

Today's pricing (meaning low cap rates) is predicated on revenue growth. Revenue growth isn't tied to interest rates, it's tied to supply and demand in the rental market, plus what other comparable properties are charging.

Here's an example:  We bought a property last year at around 4% cap.  Rents were about $940.  The deal made sense, because our analysis of comparable properties plus our experience in the market led us to believe that we could achieve $1,090 rents if we made some light renovations to the units.  We were right, we were immediately renting units at the goal rent. If you were to look at our income a year later and recalculate a yield on cost it would offer a really nice spread over our mortgage interest rate and a healthy investment return.

Fast forward to now--we are actually renting units for around $1,600 (that's not a typo)--which is a 70% increase and we've only owned the property for 12 months. This is why people are now buying at 3% cap rates...they are seeing the out of control rent growth and they know that the revenue stream is growing--rapidly.

Bill F. · Answer

@Brian Burke

I agree with your analysis 100%, but it does does come at the issue just from a Real Estate investor's perspective, which doesn't tell the whole story. Real Estate Investors like yourself think about revenue growth and the present value of all future cash flows and the best way to increase them. I don't think all market players today have this same thought process.

Some are chasing yield and RE has been opened up to vast swaths of ppl since 2008 to the increased financialization of our society.

Insurance companies may serve as a good proxy for the average yield seeking investor in this case. For years and years, at a high level, they invested their float into a few buckets, Bonds, equities, Real Estate, with the lions share going to bonds that were AA and AAA rated. This worked well when AAA bonds had a yield of 5-6%. But now that they are at 2-3%, the firms have shifted more of their allocation to other assets, RE being among them, either directly or through Asset Back Securities, because most insurance companies make all their profit from their float, so they have to keep profits up to historical levels.

I think that some logic applies to more groups and this infusion of cash to the market has had an impact on ppl looking at RE as a stable stream of cash flows, which it can be, but doesn't have to be; as you have illustrated.

Michael Dumler · Answer

@Eric Berkner investors need to understand the relationship between interest rates and cap rates. The downward trend in cap rates over the past couple of years is heavily linked to the fall in interest rates. The spread between interest rates and cap rates reflects the risk premium for real estate, and investors need to recognize this. With interest rates at all time lows, expect cap rates to follow. I'll find it amusing when interest rates start rising again, investors will complain, and once again fail to see the correlation.

Caleb Webster · Answer

@Michael Dumler cap rates might be that low for A+ assets in great neighborhoods in Portland but there are still deals at 6+ if you’re willing to go further East past I205.

Cap rates are tied to investor risk tolerance and debt is cheap so risk is less — therefore cap rates compress. The benefits to a low cap market are the returns on value add are magnified. Cash flow might be more challenging but wealth was never really made through cash flow anyways, I’d argue that the only purpose of cashflow is the servicing of debt.

Russell Brazil · Answer

Yield is a function of risk...whether it is in real estate, bonds, dividends, etc. Major metro areas on the coasts are typically low cap rates because they lower risk.

What are the risk points to consider as to why an investor is willing to take a lower yield in these markets than in the middle of the country?

Rent Growth, appreciation, lower vacancies, higher demand.

You are not just buying a revenue stream that only exists today.....you are buying that revenue stream that exists in the future. The low cap rate markets with their rent growth present a yield on cost in the future, that is higher than the static cap rate that exists in a high cap rate market today where rents are and appreciation are more stagnant.

I call this trying to think 4 dimensionally (how the asset perfoms ober time) as opposed to thinking 2 dimensionally, which is only focusing on the here and now.

Ben Nelson · Answer

@Brian Burke Nail on the head. Cap rate is only one metric. If you only get caught up in that number you'll miss a lot of opportunity.

Todd Dexheimer · Answer

If you can add value by raising rents and/or lowering expenses, then a low cap market makes a lot of sense. Cap rates are a reflection of demand and strength in a market.

Let's say you raise the NOI by $100,000/year:

4.5 cap market. That's an increase in value by $2.22 million

6.5 cap market. That's an increase in value by $1.54 million

Now, in the 4.5 cap market the rents are likely higher, so a 3% increase in rents will create more dollars in NOI increase as well. Add that to the equation and it's easy to see how in a low cap market, you could realize very high returns.

Eric Berkner · Answer

You guys are great. I have learned so much from this thread.

Allan C. · Answer

@Eric Berkner learn how to underwrite and calculate IRR, and you’ll get a better idea how low cap properties can make sense as an investment strategy.

Seth Borman · Answer

I haven't read all the responses, but think of cap rates like bond yields, and then recall that there are people that buy bonds with negative interest rates because they can lock in their losses.In that environment, a 4.5% cap rate is incredible.

Investing in low cap rates, how does it make sense?

Most Popular Reply