Sometimes I feel very dumb (CAP Rate edition)

[Dustin Beam]

Hello beautiful people of BP, 

Today is one of those days that made me feel dumb. But the good news, I finally "get" something instead of just knowing about it. 

For a long while, I felt that way about Return On Equity calcs. I knew how to run the calc, but I didn't really know what it truly meant. That's another discussion, if  you're new, and don't understand what ROE really means, learn it. 

But to my dumb-me point. Today's aha moment is about CAP rates. I've long understood how CAP rates work, and how larger commercial properties are governed by market CAP rates. What I could never wrap my head around for some reason (open mind but thick skull) was how people....and WHY people would buy at these seemingly insane low CAP rates. And there probably are multitudes of reasons. But one reason became obvious to me today.

At low CAP rates, operational improvements are more valuable than ever. Not cashflow, though. For cashflow purposes, reorganizing a multifamily to perform better is always worth what it's worth. For instance, if you can save, or earn, an extra $50k per year by improving the operation, it's worth exactly $50k (ignoring taxes and such).

But here's the real kicker, in an 8 CAP market, that $50k extra per year increases the sale price by $625k. Not bad. In a 4 CAP market, it raised the price to $1.25M. Fantastic. So buying the same property in the 4 CAP market would make the buyer (on the tail end) more money in the low CAP market than it would have made in the 8 CAP.

There are obviously other considerations like you should cash-flow better when purchasing in the higher CAP rate market (or time line). And it really applies to shorter term holds vs long term holds. However, identifying mismanaged, under market rent properties in a low CAP market is more valuable than finding them in buyers high CAP market.

And if I'm wrong, mods feel free to delete this thread haha. My face does not prefer eggs. :) 

[Account Closed]

@Dustin Beam you eluded to a key point regarding cap rates; they’re a kind of nebulous metric because they can fluctuate largely depending on how the property is operated. This is why we use gross rent multiples and price per unit metrics alongside of cap rates when valuing deal (not to mention stabilized forecasts).