small markets and smaller buildings seem to cashflow better...true??

Question

From the research I've done, it seems there is a frenzy in the "big" markets like LA, NYC, etc that has pushed cap rates on fancy Class A buildings to ridiculously low levels, while the "secondary" and "tertiary" markets have far better deals out there if you really want to make cashflow.

This seems odd to me. Why is there this frenzy in the big cities, when, as soon as rates go up, all these 4.5% cap rates will suddenly be in a situation where either the investor has to sell at fire-sale prices, or, rents would have to increase considerably?

To me (someone who has only invested in SFR and Duplexes so far) this seems like a warning siren to stay away from the big markets.

I don't see rents increasing at a rate that will make these big city buildings profitable down the road, unless these new buyers take a bath on them at some point...am I right??

It seems to me that you make more dough cashflow wise on 5 $850k 20 unit Class B or C buildings in Akron, Ohio than on one 10 million dollar Class A in New York (if such a thing even existed at that price).

Joel Owens · Answer

Joe you are not understanding a key point.

Investors such as yourself DO NOT typically invest in Class A properties for the reasons stated.The cash flow returns you want are not there.

Larger buildings that are Class A with Multifamily mainly comprise institutional buyers,pension funds,REIT's,Insurance companies.

What those companies want to do is have security OVER cash yield.So if the CAP is 4.5% going in they can eventually increase the cap through rent increases that are outpacing annual inflation rises.

Through increased rents,tax offsets yield can be increased.No it's not going to be 10% etc. but all these companies are trying to to is protect the money,grow it a little,and outpace annual inflation.

Hope you understand now why this is not a target for everyday investors.Many investors look for 20-150 units value add class B or C they can turn around instead.

Bryan Hancock · Answer

There is a lot of institutional money chasing those big deals in larger markets. The credit quality is sufficient to deliver them nice risk-adjusted yields well in excess of their cost of capital.

Larger investors generally try to position their acquisitions at product too big for the small and too small for the big. This eliminates all of the guys with a truck and keeps them from competing with large institutions that will always be able to accept lower yields given their cost of capital.

In other words...different strokes for different folks. Don't think secondary or tertiary markets are a panacea. The market for real estate is inefficient, but it isn't completely crazy. Higher yield in the absence of distress generally is pretty well correlated with higher risk. Try buying a class D apartment building and let everyone know if all of the extra work is worth the few points' worth of extra yield you can get. Value-add deals with deferred maintenance or poor management are probably your best bet if you are chasing extra yield or forced appreciation.

Account Closed · Answer

There are many ways to invest in RE. It is easy to get caught up in purely looking at cash flow, but cash flow is not the only criteria in investing.

Jon Klaus · Answer

I have a commercial broker friend who is major market and class A all the way. He says you want to be where you can get caught up in the "white hot jet stream of runaway appreciation." He speaks of being in or near the "ground zero" of major markets. When there is a bull market, values can double, triple, or more. In the mean time or in bear markets, the AAA locations hold value better than lesser locations.

Joe Delia · Answer

It's all about risk management, as Jon and Joel said.

small markets and smaller buildings seem to cashflow better...true??

small markets and smaller buildings seem to cashflow better...true??

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