Does More Units = Smaller Cap Rate?

[Jonathan Johnson]

Hello BP,

I was wondering when looking at larger apartment buildings and neighborhoods, when you get to 100+ units does the cap rate go down? I just looked at a 200+ unit apartment area for sale with a 7.5% cap rate, but I don't know if that's good. Obviously there's a lot of factors to consider, but these apartments are 96% occupied and are in pretty great condition in a B neighborhood.

[Jeff B.]

At 200+ units you will be in over your head unless you have prior experience with smaller  units!

I've posted the Great Cap Rate Fallacy here, but you need to decide what ROI you demand for the work it takes to manage such a complex.

[Zach Quick]

@Jonathan Johnson Not necessarily. Don't think about cap rate so much from that perspective. Cap rate is more local based than size based, and who knows if that 7.5% cap rate is truly a 7.5% cap rate, depending on the broker's assumptions it could really be a 3 or a 12.

[Joe Hughis]

The number of units in-and-of-itself would not decrease your cap rate, per se.  The main factors of determining cap rate are: sales price, gross income and soft/hard operating expenses.  

7.5% cap?  Whether that is good or bad depends on the surrounding neighborhood, your expectations/plans, and the circumstances surrounding the property expenses.  In most of the major cities in the country a 7.5% cap on a 200 unit property would be amazing (given all other factors being consistent with the surrounding neighborhood).  However, if surrounding properties to that property are selling at an 8+ cap, then you have to determine if the price of the property is too high or possibly look deeper into the property's expenses. 

[Jonathan Johnson]

Thanks @Zach Quick and @Joe Hughis,

I'm having a hard time following the correlation between the cap rate and the local area. If the properties make a certain NOI and are selling for a certain Purchase Price, what does location have to do with whether those numbers a good or not?

Is it just about making sure you're getting a good deal compared to all other properties on the market?

@Jeff B. I wouldn't be managing the properties.

[Zach Quick]

@Jonathan Johnson It's a reference point for local market I'd say. The smaller a market the more pointless CAP rate becomes, in my opinion. I'd probably figure out what it's trading at per door compared to other similar properties are trading at per door and work from there.

[Joe Hughis]

@Jonathan Johnson - Location dictates price. The more "attractive" the location, the higher the market price the property will command and the lower the cap rate will be, regardless of NOI. After all, when you are first going into a property, it's income and expenses are relatively set.

That being said, if in that location properties are selling at a 5% cap and you found one that legitimately offered you 7.5% cap then you found a great deal for that location.  Some real estate investors are strictly cap buyers and would rarely considers a property's location in determining a property's worth to them.  However, other's will take into consideration the strength of a property's value and potential to increase in value (among many other factors) as compensating factors to a accepting a lower cap.  This strategy can be part of an investors greater portfolio diversification.

But to answer you last question, it is about what your ultimate plan, strategy, and investment style are.