When you purchase a property, what cap rate do you look for?
Is there an industry standard or do you have a number that you personally like to see?
No. It’s all local. However, frankly it comes down to what the competition will bear, and what you can negotiate.
Think of it this way: Ask yourself, "What is the minimum return on my investment, from a given deal, considering it’s condition, future value, likely cost to operate, etc. if I paid cash? Whatever that percentage that comes to, is what the cap rate needs to be. Of course with leverage, you can increase the return multiple times, but that’s for a different discussion. You can make money more than one way, and cap rates only reflect a most basic way, an all-cash return.
What cap rate someone else will accept, is a matter of experience, judgment, profit potential, and the market conditions.
That said, you can get a good idea of what cap rates are likely acceptable in your area simply by asking a commercial broker. And he’ll break down the grades and cap rates generally accepted for each grade, size and price point (maybe).
For example, most investors where I’m at (Newport Beach) will take into consideration appreciation, competition, and likely rental increases, and pay anywhere around a 3-4% cap rate.
However, when I was in Kansas City metro, we would buy anything we could negotiate to a 13% to 15% cap rate, and sell it to California investors at a 10% cap.
So, it pretty much depends on local demand and our ability to negotiate what we want.
Now, if you had been going through 100 operating data sheets as I’ve suggested elsewhere, you would already know what the generally accepted cap rates are for the area, grade, size, and price point, and perhaps structure.
And frankly, I would know precisely what the market cap rates were, for all those variables, and use that to negotiate something better than the average market cap, so that I could make money when I bought, and not have to wait for appreciation, inflation, or forced appreciation. Just saying.
FWIW
Wouldn’t leverage mean less profits? Doesn’t leverage mean that you took out a loan and have to make loan payments?
I am not the buyer for the company that I partially own. I don’t think a realtor would waste their time sending me financial statements of 100 different properties. Is there any way for me to get statements without the use of a realtor and make sure they are accurate? I have heard that the numbers quotes on websites like Loopnet are not always accurate.
Here’s a sample analysis of those two deals. It’ll take some more explanation, and clarification, and it’s not anywhere near a full analysis, but it’ll give you an idea of what to look for, etc.
Seller “A” Operating Data Sheet Analysis
http://jaypalmquist.com/images/Seller_A_Analysis.png
Seller “B” Operating Data Sheet Analysis
http://jaypalmquist.com/images/Seller_B_Analysis.png
Seller B’s deal assumes the 22% vacancy factor is not the result of the rents being too high, but the manager just being too lazy, and incompetent, to lease up the empties. Of course, that’s a stretch, but it works for our discussion.
So, it would appear that Option A would be the better purchase.
It all boils down to cap rate, right?
That’s the way I see it. Not stated cap rate or pro forma, but what I think (after careful research and possibly a feasibility study) I will get out of it.
It’s just like picking the stock with the highest dividend.
No. I would negotiate for Option B. The seller is more motivated, because he can’t seem to manage his project correctly, much less profitably.
Nobody is going to pay full retail for a significantly under performing project, and so when I offer the seller $1M, less whatever it will cost to fix it, he’ll say yes, just to bail on the headache. I mean he’s paying for management and losing $60k a year at the same time.
Seller “A” is doing his own managing, letting the rents get too low, and is likely not that motivated, since he’s quite fine with coasting on his current operation. If he gets his price, great, if not he’s no worse for wear. I know his rents are 10% below market, because if they weren’t he wouldn’t have a waiting list. Nobody has waiting lists, until people start discovering how REALLY low his asking rents ‘are.’ And probably not much needs to be done to justify raising the rents, and so this is a deal that doesn’t take much, to create nearly a quarter million dollar equity profit. This will require $200k in cash to buy.
Seller “B” is having a tougher time. He doesn’t have a waiting list; he’s got five or six empty units chronically vacant; he’s paying for management that’s screwing him out of over $60k a year in lost income; and is making the building practically impossible to get financing for, at a reasonable rate and term. Thus making it a prime candidate for temporary “subject to” financing. In that case, I negotiate to take over the seller’s first loan; because he owes practically what the building is currently worth to me, in its present condition and operation.
So, I offer the seller his loan balance of $890,000 plus a no-interest, no-payment, second for say $100k, for a total price of $990k. This is a no down payment deal, because I told the seller that I didn’t want to make two down payments on this property; one to buy, and another to fix it. So, my ‘fix it’ money is my down payment. He agrees. I take over his payments, get the deed, and the seller waits for me to pay him off in say five years, or earlier depending.
I fire the manager; hire my own; lease up the units; kick out the late payers and scoundrels; and a year later, I’m operating at a 5% vacancy rate, after raising all the rents 7%, now that everything’s being maintained, the lawn’s mowed, the lights work, the pool’s open again, and tenants are happier that the place is being cared for.
And with the $300k equity I negotiated and captured at the purchase, and the forced appreciation I created with the increased rents, I’ve made another $200k in equity for a grand total of $500k in equity profits in twenty-four months. That’s a profit of $250k per year of ownership. Of course, it will take a year or two to prove its performance in order for a new buyer to get decent financing, but meantime, where else am I gonna make $500k just by improving the management application?
Meantime this will cost me approximately $250 in notary and recording fees to buy.
So, all things considered, I want Seller “B’s” deal. No down. High Upside. Equity profit at the get-go. Yay for me.
What if you were looking to hold long term? With no plans of every reselling this property? Would that change things?
That is the situation that I’m in.
Nobody said you ‘had’ to make it a short term play.
You could easily refinance, and hold on to the property, once it offered a solid performance history.
However, wouldn’t you buy both these properties, since you could theoretically get into “B” for nothing?
Am I correct in thinking that option B would require that the seller is willing to owner finance?
And that you suggest refinancing because you could take out a 20 or 30 year loan instead of the 5 year loan that you had with the owner? Am I following you on this?
Yeah, I was getting ahead of you on this…
“Sub2” is where the seller is effectively financing you, by enabling you to take over his loan, and giving you his deed. This is very common on commercial transactions, where the party’s have some mutual sophistication (aka trust).
In the example, I suggested that you negotiate a zero-interest, zero-payment seller-carried 2nd for about $100k, payable in a lump sum, sometime over the next five years. This is not an unusual term for short term notes on distressed real estate, with motivated sellers.
Of course, it’s all about flexibility and motivation levels.
The more familiar we are with our operating data analysis, the more confident we’ll be about our offers, and in our negotiations. That way, we’re certain that our ‘golden opportunities’ are not ‘fool’s, golden opportunities.’
Meanwhile, nobody steals in slow motion. We don’t want to wait for our competition to confirm our suspicions.
FWIW
Hi,
Typical cap rates are subject to property class:
Class A Properties normally have a 4 to 8 cap rate. (4,5,6,7,8)
Class B Properties normally have a 9 to 12 cap rate. (9,10,11,12)
Class C Properties normally have a 13 to 17 cap rate. (13,14,15,16,17)
Class A: These properties represent the highest quality buildings in their market and area. They are generally newer properties built within the last 15 years with top amenities, high-income earning tenants and low vacancy rates. Class A buildings are well located in the market and are typically professionally managed. Additionally, they typically demand the highest rent with little or no deferred maintenance issues.
Class B: One step down from Class A, these properties are generally older than Class A, tend to have lower income tenants and may or may not be professionally management. Rental income is typically lower than Class A along with some deferred maintenance issues. Mostly, these buildings are well maintained and many investors see this as a “value-add” investment opportunity because through renovation and common area improvements, the property can be upgraded to Class A or a Class B+. Buyers are generally able to acquire these properties at a higher CAP Rate than a comparable Class A property because these properties are viewed as riskier than Class A.
Class C: Class C properties are typically more than 20 years old and located in less than desirable locations. The property is generally in need of renovation, including updating the building infrastructure to bring it up to date. As a result, Class C buildings tend to have the lowest rental rates in a market with other Class A or Class B properties. Some Class C properties need significant reposting to get to steady cash flows for investors.
GR
This makes sense why my RV park is at around 17% cap rate.
Why would anyone ever buy a Class A property then?
Should I just stick to Class C’s?
This place was able to rent out right away, but it did need a significant amount of initial maintenance and could still use quite a bit of improvement money to turn it into the “Beverly Hills of Trailer Parks,” which I intend to do.