Seattle 2-4 unit CAP rates? Really?

[Christopher J.]

I would like to buy my first income property...I'm focusing on 2-4 unit residential in Seattle. I'm reading tons (just found this site via Frank Gallinelli's books and it's awesome!), talking to friends who invest in real estate and analyzing the market data. The market data has me totally discouraged.

In the last 2 months, about 24 properties of this type have sold in the area of Seattle I'm focused on. The average CAP rate is 4.2% based on NOI = 60% of gross rents (I know every property is different but I'm told this is a decent rule of thumb). A typical example is triplex with $35,500 in gross annual rent for $500,000....

35,000 * .60 / 500,000 = 4.2%

I'm calculating that I'll need to put down 40% on a deal like this to achieve a bank required debt coverage ratio of 1.2!! With NOI growth of 2.5%/year my IRR is like 5-6%. I can play around with the numbers a bit but it doesn't get much better!!

Am I analyzing this wrong or am I just in a bad market to buy income properties? I don't want to be greedy but I want to earn more than 5-6% here!

[Zach Schwarzmiller]

Welcome to BP Christopher!

I advise my clients looking to purchase/sell 2-4 unit properties to not focus on cap rates. While yes, near core Seattle cap rates have been typically trading between 4.5-5%, I would suggest you rather, or at least in conjunction with cap rates focus on the gross rent multiplier. Expenses are going to vary dramatically on residential (2-4 unit properties). On commercial multifamily (5+ units, I would generally start at 6+ units for my personal underwriting) cap rates tend to make more sense in my analysis as your able to achieve economies of scale.

Example (let’s use North Seattle):

1. Four-Plex A: 4 identical 500SF units rented at $1,000 a month ($2/SF). Typically you will see a much higher $/SF in smaller units. Annual Rent: $48,000. Expenses are $3,000/Unit/Year. Annual Expenses $12,000. NOI: $36,000 @ 4% CAP = $900,000 "market value". This would translate to an 18.75 GRM when realistically the GRM should probably be around 15 which would represent a value of $720,000.

2. Four Plex B: 2 1,200SF units rented at $1,350 ($1.23/SF) and 2 1,300SF units rented at $1,400 ($1.08/SF). Annual Rent: $66,000. Expenses are $3,500/Unit/Year. Annual Expenses $14,000. NOI: $52,000 @ 4% CAP = $1,300,000 "market value". This would translate to a 19.7 GRM when realistically the GRM should probably be around 15 which would represent a value of $990,000.

Nonetheless, if you’re buying in Seattle some would say you’re buying at the peak of the market. We still have a lot of new units which are due to come on the market soon which will likely show more concessions and slower rental growth in the coming future. Wish I had a crystal ball!

Sounds like you understand IRR and cash-on-cash return, which is overall more important in your analysis than anything. You may want to consider purchasing in South Snohomish County or South King County / North Pierce County. These areas have not seen the levels of new development core Seattle has and still are showing low vacancy and strong rent growth. My personal rule of thumb is keep your investments within 2 hours drive and make sure there is a growing micro-economy within the area.

On a triplex I am closing on in Snohomish will yield me a 12.4% IRR on equity as it is currently operated (I used a 10 year hold, $ allocation for capital improvements and factored in my actual mortgage payment). If I were to get all units to where 1 of the units is rented, and then see a 2%+ Y/Y in rent it would yield me a
16.5% equity IRR.

This is easier for me to explain face-to-face, hopefully it makes some sense. Everyone has a little different underwriting style. If you’re interested in grabbing a coffee sometime I am happy to meet up.