Should identical properties on same rd have different cap rates?

Question

I know there are a bunch of posts about cap rate and I've read quite a few. However, every time I think I understand, I'll see something in a listing that confuses me.

My current interpretation is that a cap rate is set by the market - meaning it reflects what sellers are willing to pay for a property/return on investment. So in hot markets, cap rates will drop and sales prices go up because people are willing to pay more for a property. In 'cool' markets, the cap rates increase and sales prices drop because not many people are buying or they are holding out for better deals.

If that is correct, then if I have 2 identical properties next to each other on the same street, in the same condition, shouldn't they be the same cap rate?

I received a small portfolio of off-market properties for review. The seller is in the process of doing some upgrades before listing them so I'm trying to make an offer before upgrades are finished. Given my luck thus far, I'm not holding my breath for success but I am hopeful.

Two of the properties are 8 units each. Both properties are right beside each other on the same street. Both are pitched roofs with brick exterior. Both are fully rented. The leases in both units are below market by varying degrees - the annual gross rent on the one is about $3k more than the other. Also, the one has $1k more in property tax than the other.

The seller sent separate financials for each property. Barring the taxes and rental income, all other fees are the same between the two. The list/sales price is also the same price for each property but they are using a 6.6% cap for the one and a 7.5% cap for the other. Shouldn't they both be either 6.6% or 7.5%? I think they are only changing the cap rates so that mathematically both properties keep the same sales price. However, that's not how cap rates work, is it? I thought they were the one thing that should be fairly constant between property types/location/quality so that you had a consistent way to determine value?

Sam Grooms · Answer

Cap rates are an output, not an input.

Once you get down into the smaller unit count, price per unit/door will usually be the driver for price, which appears to be the case in this property. As you move up into larger multifamily, prices will be based on returns. This takes into account the type of financing I can get. What's my cost of capital, both equity and debt. This has a huge affect on how much I can pay for a property, but isn't accounted for in a cap rate.

Also, in a hot market (which is most markets at the moment), future value-add can get priced in to the property. In Phoenix, stabilized properties go for around a 5%. However, value-add can get down to the low 4's. This could be for identical properties, just one has better management. You're paying a premium, because the seller's broker knows you'll be able to bring up the NOI. But people are willing to do it because maybe the value-add is bringing my cap rate all the way up to 8%. So sure, you're giving the seller some of your upside, but if the alternative is waiting years for cap rates to go up, you might be waiting a while. Better to have a slightly smaller piece of a large pie, than no pie at all.

All of this to say, most people aren't buying on cap rates, whether you're looking at small or large multifamily. There's so much more that goes into it.

Christa S Rickard · Answer

Wow.

Seriously, I just had this epiphany as I read this. And it's stupid because I've read similar things before and, at the time, knew what they were saying because it made complete sense to me. I thought, 'well, yeah. Obviously.'

But I didn't "get" it until just now as I read your post. And it's not something I haven't read/heard before, but this time - something clicked - tumblers fell into place and a door just cracked open.

And I can't even put into words how stupid I feel right now.

Thank you, Sam. You posted exactly what I needed to hear, exactly when I needed to hear it.

Sam Grooms · Answer

That's understandable. The more you learn and more sophisticated you get, you'll start to calculate your offer price based on the cash flows and cash on cash returns, and not on a cap rate.

Here's a scenario for you: Say you keep making offers at the average submarket cap rate, 7.5%. However, none of them ever get accepted. You see the eventual closing price, and notice that you keep getting outbid by someone willing to pay 7.0%. Would you be willing to pay 6.9% and start getting those properties, or stick to your guns at 7.5%? Would your answer change if you were able to get a lower interest rate than that guy?

What if interest rates dropped 50 basis points in 2 months (like they just did)? I can now pay a lower cap rate for the same cash on cash return. If I underwrite to a return, I can take advantage of that interest rate decrease. If I underwrite to a cap rate, I have to wait 6-12 months for other people's transactions to show up on a report, and see that cap rates have decreased as a result of that lower interest rate. But by then, the interest rates might have changed again, and I'm still left out. Or worse, interest rates went back up, so the people who underwrite to cash on cash won't pay as much, but you see their cap rates from 6 months ago and think that's where the market is, so you overpay.

Cap rates are an output, not an input. Learn to calculate your offer price based on your return requirements (10% cash on cash, 15% IRR over 10 years, etc), and you'll be better off.

Sam Grooms · Answer

10% average cash on cash over 10 years and 15% IRR is definitely achievable. However, we buy in a 5% cap market, so obviously I'm not buying that cash flow. I'm creating it. We go in and spend $15K+ per door to completely renovate the property, and we're able to increase rents $300-$400 as a result. If we weren't doing such a heavy lift/repositioning, you're right, I'd have to pay 30-40% less to get those returns.

Russell Brazil · Answer

Capex is NOT a factor in cap rate btw

Greg Dickerson · Answer

A seller can ask whatever they want for a property. It’s the buyer who ultimately sets the price. Property is worth what someone is will to pay. CAP rates and comps don’t matter.

Christa S Rickard · Answer

Are you able to find deals that meet 10% cash on cash, 15% irr over 10 years, Etc? That's the part that I'm struggling with. When I plug in the numbers to the BiggerPockets calculator, I'm lucky if I can get $100/unit/month cash flow and 8% cash on cash return and that's after I lower the list price by usually 30 or 40%. I just don't see how people are making these deals work financially.

Christa S Rickard · Answer

Sam, I think you're correct regarding the unit per door calculation  as they also mention the price per unit is $66,000.

I wasn't basing my decision of whether or not to make an offer because of lower cap rate. Rather understand why identical properties were listed with different cap rates. It appears that I'm still struggling to fully grasp what a cap rate is. I'm getting there though.

My criteria for an offer is based on cash flow as well as cash on cash return. I only use cap rate to calculate my offer price.

Christa S Rickard · Answer

Hmm... I did not know that. They both are supposed to be in the same condition although I have not yet seen any inside pictures.

When I was running the numbers, I saw that they did not include any capex in their expenses and their vacancy and property management was slightly low. By modifying those three variables ( increased Property Management to 10%, increased vacancy to 5%, and included 10% for capex) and using their cap rate, I'm coming in almost half of their list price. I wanted to make sure I understood why the properties are different cap rates before I finalize my numbers, so thanks for the help.

They will probably balk at my offer since it's so far below their asking price but that's the value based on the numbers.

I'm still excited that I finally got an off-market lead but not so excited that I'm going to overpay.

Heath Ryans · Answer

@Christa S Rickard

Cap rates are area specific, yes. But there is generally a range. 1% or so of flex. It depends on location (which you said is the same) and the overall condition of the property. If its a nicer property, you could base its valuation off a lower cap rate because there is less risk (theoretically). On the flip side, if a property needs some work or anything that would imply more risk, it would likely be valued based off a higher cap rate.

If the location and condition is mostly identical, then it's really just owner/agent discretion at how they manipulate the cap rate to get their valuation.

Should identical properties on same rd have different cap rates?

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