Cap Rate Limit

[Carl Stewart]

What's the lowest cap rate you will take? What's the average (good) cap rate you like to see?

[Fred T.]

That depends on the Asset Class, Location, Overall Business Plan and Asset Planning...so as you can see, it's a loaded question.

SFR properties should not be acquired based solely on a CAP Rate. As a matter of Fact, I don't even pay attention when someone is trying to sell me a SFR with a large CAP rate, all it means is the person doesn't understand the Industry or missed some expenses / matrices in my book.

SFR properties should be valuated based on the Sales Comparable Approach coupled with GRM, ROI and/or Monthly Cashflow. If the comps are good, and the property produces a cash flow of at least 1.45 DSCR (with no major CapEx projected in 5yrs) or better for a Hold Strategy or an ROI of 15% or better on a short term Flip, then I would look more into the deal.

Commercial and Multi-Family Assets are a different story of course.

Class A assets -- and Class B assets located in major markets -- typically command more interest from lenders. Life companies, pensions, REITs, agency lenders and conduits aggressively pursue Class A assets. As a result, you can expect:

• More financing options
• Lower rates
• Longer fixed rate terms and amortizations
• Higher leverage (up to 80% with options for mezzanine debt or equity)
• Asset is primary source of collateral with no personal guarantees (non-recourse)
• Lower debt service coverage requirements (as low as 1.15:1)
• Depending on the market, CAP rates in the 4%-6% range

Class B and C assets lose some interest from institutional investors and borrowers typically obtain financing from banks, agency lenders and specific purpose REITs. As a result, you can expect:

• Fewer financing options
• Slightly higher rates
• Fixed rate with balloon terms or 5 year resets
• 75% leverage with no option for secondary debt
• Non-recourse for assets located in major markets
• DSCR of at least 1.25:1
• Recourse for assets located in secondary and tertiary markets
• Depending on the market, CAP rates in the 6%-8% range

Class C and D assets tend to be financed by local banks with little to no interest from secondary market lenders. As a result, you can expect:

• Limited financing options
• Rates 100-200 bps higher than higher quality assets
• Shorter fixed or floating rate terms
• 65% (75% for strong sponsors in major markets) leverage with no option for secondary debt
• DSCR of at least 1.43:1
• Personal recourse
• Depending on the market, CAP rates north of 8%

As an Investor, I would want to be acquiring my assets at 2-4% above the stated CAP Rates, then stabilize, create added value and sell off around the CAP Rates mentioned above. That of course is only 1 Strategy and usually takes up to 2yrs to accomplish.

NOTE: It is important to note that Industry Average CAP Rates change quarterly, so one has to always have their research updated each quarter to stay on top of market trends. One final note is, the above CAP ranges are based on National Averages and EACH MSA and Community may have a different CAP rate assigned to it...this is where your TEAM of Real Estate and Financial Professionals come in to play to assist you in your particular community. 

Investopedia States: 

DEFINITION OF 'CAPITALIZATION RATE'

"A rate of return on a real estate investment property based on the expected income that the property will generate. Capitalization rate is used to estimate the investor's potential return on his or her investment. This is done by dividing the income the property will generate (after fixed costs and variable costs) by the total value of the property. If you want to get technical, it is basically the discount rate of a perpetuity."

So in closing, CAP Rates are only a small sliver of the overall assessment (though frequently used to derive a FMV on most asset clases other than SFR) and if that's all you know, you may not make it in this industry. You may want to look into some other Acronyms like: GRM, EGI, NOI, OER, DSCR, IRR (2 versions), COC, ROI, CPI, GDP, etc...all of which mean something and collectively can be used to assist you in your acquisitions and exit strategies and ultimately can effect the CAP Rate.

Bottom Line: There is no One Size Fits All special "CAP Rate"./

Happy Investing!