At current CAP rates is it worth it?

Question

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 · Answer

@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

Andrew Johnson · Answer

@Sanjoy V. I think this really depends on what you think the future of Austin is as a city. Since it's cap-rates you're talking about I'm going to assume that it's multifamily commercial. So value is dependent on NOI and cap-rate more than the appraisal of the property down the street. Do you think people will still be coming to Austin in 5 years? Do you think that population growth will make those "closer to downtown" apartments disproportionally more valuable? And will that value turn into higher rents? It's the same question you have to ask yourself in any "hot" areas over the last ~5 years like Austin, Denver, Seattle, Nashville, etc. you have to ask yourself the same question. So that's "Part 1"...Part 2 is you question about waiting it out. That really has a lot do with how you think interest rates will progress over the next ___ years. If they keep going up then you're missing out on "cheap capital" today which will allow you to get into a property and use the portion of the mortgage that goes to principal to pay it down. It's not a huge percentage in the beginning but it's something. If you wait 5 years you'll have missed out on 60 mortgage payments and if interest rates get bumped I don't think it's crazy to think of a 7% interest rate 5 years from now. How much would the property value have to drop (which would increase the cap rate) to generate any CoC return at a 7% interest rate? Do you think that will happen? It's pretty easy to put a few scenario into a mortgage calculator to get your answer. I don't buy in Austin but I know I stress-test my scenarios (where I have commercial mortgages) and look at a really bad scenario: "What if my collected rents (either by vacancy or demand drop) decrease by 20% in 5 years and mortgage rates are at 7%?" I look at what the new loan balance will be when I have to refinance and see if I will a.) continue to make (less) money, b.) break-even, or c.) start to hemorrhage cash.Now what are the odds that my collected rents drop 70% while interest rates are rising? Pretty low. I'd imagine that scenario is pretty unlikely in Austin as well. If there's some bad economic issue(s) that arise causing people to not be able to afford rents I doubt the fed will just keep raising rates, but, well...who knows. Bottom line: run your own hypothetical scenarios, stress test your results, and you'll be able to at least apply some analysis to downside risk.

Andrew Johnson · Answer

Sanjoy V. For whatever it's worth, tertiary can swing a little more up and down in my (sample size of one) experience. I'm guessing people will value living in Austin, especially with that being a work hub. If you run too far outside that range to see a materially better cap-rate you yourself up to upside and downside. Some of this boils down to tradeoffs particular to Texas. If you to a tertiary market outside of Austin so I make $100/month more or $1,000/month more? This is one are where I'd look at the "real dollar" cost perhaps closer that percentage metrics. You don't want to chase cash-flow only to figure out it's another $50/month for a location that you don't believe in nearly as much. This is definitely a "to each their own" tradeoff scenario.

Diane G. · Answer

Not worth it is my answer.... if you have millions, age 70, and looking to NOT lose money, then yes it is worth it...

David Thompson · Answer

Sanjoy,Some good points made above. I live in Austin but we are not buying large value apartments here. We think there are some better entry points in San Antonio and Dallas, the latter where we've purchased 8 200+ communities in the past 18 months. The numbers must make sense, value add B focused, and conservative underwriting. We are continuing to buy opportunities in the strongest submarkets of Dallas. Cap rates have not moved despite 3 interest rate moves as investor demand for MF assets trump those moves to date. That said, you should underwrite for increased cap rates, you can use variable rate but use options strategy to lock if things hockey stick, re-look at the market in 18-24 months and refi / look to exit. Most investors should think 5 years and that is important to have staying power out at least 7 however savvy syndicators get out earlier. We see nothing near term concerning us in the DFW market from a demand standpoint. Prices are getting higher and you need to be an experienced player who's done a lot of deals in your target market to get better looks (some off market) from your broker.

Josh Clary · Answer

not sure if I am allowed to do this or not. if not just inform me and I will erase and abide by your wishes. at any rate I buy and sell a little land here and there with the market i am In, I run across houses and commercial properties for sale all the time. I am local out of Dallas living in Carrollton with office in Carrollton. I am looking to network with like minded people who can utilize my services and can teach me more about real estate. For all you in the commercial side of things I am a GC, and can come in and show you how to fix up your property from top to bottom at very minimal cost to you. No I am not a storm chaser nor a fly by night company who has bullcrap to offer. I can provide tons of local references as well as multi states. Some of my clients we take care of there accounts are Pilot gas stations, Flying John, Wells Fargo Bank, Backyard Burger, and Legacy Apartments. You do not get these types of clients and keep them by being subpar. I am a member of this site in hopes of networking with people who we can build a long standing mutually beneficial relationship and help each other grow along the way. Anticipating replies to this comment and hope everyone has a blessed day!

Adrian Chu · Answer

I agree with the others here. Value add opportunities are a great thing to look for in this market.

Sanjoy V. · Answer

thanks for your reply

Account Closed · Answer

@Sanjoy V. If your primary objective is cash flow, you would look into markets that have a positive cash flow from the get go and if the mortgage rate equals or is lower than the cap rate, cash flow will often be negative. So if mortgages are 5% in a cap rate environment of 3%, that can be a problem for the cash flow investor. When you say waiting for cap rate to increase, that can vary drastically between markets. For investors where the primary objective is appreciation, they may not care what the cap rate is or if property cash flows as the purely cash flow investor would.

Russell Brazil · Answer

Often a low cap rate is not only indicative of strong asset price growth, but also strong rent growth, and I would say even primarily based around rent growth. When you look at the property after a couple years of high rent growth, and measure that against acquisition cost, suddenly the return looks pretty good...it just involves a little more patience.