At current CAP rates is it worth it?

[Sanjoy V.]

With the current CAP rates, some places in Austin are at 4-5% at best, the question is how far can you compress the cap rate if you are buying at these low rates and sell 5 years later? are you really depending only on appreciation?

What will happen to these cap rates when interest rates go up? they may go up in order for people to buy them at high interest rates? which will make things for people buying at low cap rates? 

So, is it really a good time to invest in Multifamily, or should you wait out for the CAPs to improve? wanted thoughts on some of the BPs...

[Jonathan Twombly]

@Sanjoy V. I can't speak for others, but we are not buying at the moment. Right now, the risk is extremely high, for the reasons you mentioned. If your model requires you to sell within 5 years, or if you run into trouble that requires you to sell or refinance within that window, there is a great deal of risk that cap rates will be significantly higher than they are now AND that rent and NOI growth will have not been large enough to overcome the rise in cap rates to net out at the right dollar amount on sale.

Any number of things could cause cap rates to rise - slowing rent growth, rise in interest rates, investor fatigue, investors being priced out, some economic shock.  A number of these things are either happening now or are about to happen, and that suggests to me that a rise in cap rates in the next 12-24 months is coming.

Although I am not buying at the moment, if you were determined to buy now, here are a number things I would suggest to protect yourself.

First, buy for as much cash flow as humanly possible.  You need to make sure that you meet your debt service, and that you would continue to be able to meet your debt service (plus whatever coverage requirement the lender imposes) even if occupancy drops during a downturn.  Build in as much of a margin of safety as possible.  Also the cash you receive will offset the decline in asset value.

Second, plan on a long-term hold, with long-term financing. Make sure that you are neither forced to sell or forced to refinance at a bad point in the market, before you have had enough chance for rent growth and NOI growth to overcome the decline in value that a rise in cap rates will cause. You want to give yourself enough runway. If you hold long enough, it really won't matter what the entrance and exit cap rates are, but that holding period is very likely more than ten years if you are buying at this point in the cycle.

Third, don't buy in marginal areas or marginal submarkets that investors will be the first to abandon when the inevitable bad times come.  I would advise against buying in markets, for example, that are not displaying strong population growth and/or are dependent on a single employer.  I see many people here chasing deals in markets with high cap rates, where the high cap rates are necessary to account for the risk of flat or declining population growth.  Just think about it - if a market is at an 8% cap now, what will it be when cap rates rise everywhere?  This probably doesn't apply to you, since you are looking at Austin.  But just a factor to keep in mind.

Hope this helps.

Jonathan