Have you ever been confused about something that should be perfectly clear?
Like the ongoing mystery of semi-boneless ham: does it have a bone…or not?
I think a lot of investors are confused about why cap rates on some value-add deals are lower than cap rates for similar stabilized deals. With the help of my friend and fellow BP author, Brian Burke, I’ll try to solve this mystery in this post.
Please note that this issue goes much deeper than just solving a riddle. This speaks to the whole strategy of buying value-add vs. stabilized properties. It delves into the thesis for buying and optimizing properties with hidden intrinsic value.
As I’ve discussed in many posts, this thesis is critical in times like these, where the real estate market has soared to new heights, and some investors are overpaying. Acting on Brian’s advice can help you make a profit and build wealth in any market climate.
What is a cap rate, anyway?
This confused me in my earlier years as a real estate investor. The cap rate is a measure of market sentiment. It’s generally calculated as the unleveraged rate of return on an income-producing property. Here’s the formula:
Cap Rate = Net Operating Income ÷ Value
The cap rate is generally outside the commercial syndicator’s control. It is like the price per pound when buying meat. It is the price per dollar of net operating income (NOI).
Some ask how to calculate the cap rate for a property they want to invest in. You can estimate this as the unleveraged return for a property like this in a location like this at this time and in this condition. You can learn more about the cap rate in this post.
A lower cap rate for the same asset means a higher property price. And vice versa for a higher cap rate. So when comparing different assets, one would think the cap rate for a stabilized property is lower than a value-add property. Here’s an example with the reasoning:
Tanglewood Apartments is fully stabilized and running like a top. Rents are at market levels, occupancy is near 100%, marketing is optimized, and management is a well-oiled machine. The net operating income is $1 million.
Institutional investors want low risk and stable returns. They don’t want the hassle and uncertainty of making upgrades, evicting tenants, and replacing management. A private equity fund acquires this property for $25,000,000. This is a 4% cap rate ($1mm ÷ $25mm = 0.04).
Down the street, Pebblebrook Apartments are a mess. Their vacancy is high, their rents are low, and they’re having difficulty keeping staff. They have more units than Tanglewood, so their annual NOI is also $1 million.
The private equity firm passed on this deal since they were seeking stability, predictable income, and a lack of hassles. An aggressive regional operator with a turnaround plan bought this deal for $20 million. This is a 5% cap rate ($1mm ÷ $20mm = 0.05).
Now the private equity firm should enjoy a predictable $1 million annual (minus mortgage payments) cash flow stream from Tanglewood with little concern. The regional operator may struggle to operate Pebblebrook, but they can add revenue with some heavy lifting.
It was predictable. The stabilized asset brought a lower cap rate (higher price) than the unstabilized asset. And this provides a rule to calculate cap rates for other deals, right?
Why do unstabilized assets sometimes have lower cap rates than stabilized ones?
In my previous BiggerPockets post, I went out on a limb and discussed why cap rates don’t matter as much as I once thought. I even postulated that an asset could be a good deal at a zero-cap rate. You may want to consider those thoughts as we see how Brian Burke eloquently dealt with this issue below.
Recently, Dennis Kwon posted a wonderful question on this BP forum. He said:
I’m reading through Brian Burke’s book – The Hand’s Off Investor. In the section discussing Cap Rates, I’m having trouble wrapping my head around why this statement is true: “Cap rates on stabilized properties tend to be higher than cap rates on properties that require value-add.”
My internet search and search through BP forums leads me to believe that stabilized properties should have lower cap rates…
After explaining his question, he concludes:
What am I missing here—and what concepts am I misunderstanding?
First of all, this question and the replies that followed remind me of the great value of the BiggerPockets community. Dennis, a self-described “newbie,” put himself out there. And he receives world-class counsel from several investors, including Brian, an author and one of the most successful operators in the multifamily realm.
I can’t top Brian’s response through paraphrasing, so here it is…
The disconnect here is you are attempting to compare apples to oranges: cap rates for a “value add” versus “class A.” This is kind of like saying, “Which is faster, an airplane or an aircraft.” An airplane is an aircraft, but an aircraft doesn’t have to be an airplane, it could be a helicopter, glider, or balloon, too. Same goes here. A “class A” could be a value add. Or not. And a value add could be a class A. Or not.
Instead, let’s compare like for like:
Deal #1: A class A that is fully stabilized and rents are roughly equivalent to the comps (meaning there’s no value-add potential here), versus
Deal #2: A class A that isn’t as well amenitized as its peers, the management is disorganized and hasn’t kept up with rent increases, the interiors, while nice and certainly up to class A standards, lack some basics like stainless steel appliances (it has white) and a nice tile backsplash in the kitchen.
Clearly, they are both class A, and clearly, deal #1 is NOT a value add. Deal #2 is a value add–by changing out the appliances, adding a tile backsplash, improving the gym, adding a dog park, upgrading the signage, and putting professional management in place that has its eye on the ball, the new ownership can achieve significantly higher rents than the property is currently getting. No higher than deal #1, but equal to it.
Now let’s examine the purchase.
Deal #1 has NOI of $1,000,000 and is selling at a 4% cap rate, so a price of $25 million. Deal #2 has NOI of $750,000 and is selling at a 3.5% cap rate, so we’ll call that $21.5 million. YES…see here that the value-add deal is a LOWER cap rate?! Now, let’s work beyond the purchase to see why.
Deal #1’s year 2 NOI is still $1,000,000 because rents were at top of market and there was really nowhere else to go.
Deal #2’s year 2 NOI is $1,000,000 because the new owner made the improvements and changes listed above. (We’re talking theory here, it probably takes 2-3 years to do this but doesn’t change the logic behind the concept.) Let’s say it cost them $1 million to do all of that.
Now let’s examine where both owners are.
Deal #1 has $1M of income for $25M, giving a yield on cost of 4%. (For simplicity’s sake, I’m not adding in closing and financing costs because they’ll be roughly the same for both and overcomplicates an already complicated discussion).
Deal #2 has $1M of income for $22.5M ($21.5M purchase plus $1M improvements) for a yield on cost of 4.44%. So who came out on top? Yes, Deal #2, despite paying a lower cap rate for a value-add property. Same income, lower basis, and higher yield on cost, despite lower cap rate.
The answer as to why value add trades at a lower cap rate than stabilized deals is because buyers are willing to pay a premium for an income stream that they can grow.
That’s the end of Brian’s comments. And like I said, other than bolding his last paragraph, I couldn’t improve on his reply. Note that his wisdom was generated through experience over decades of hard work.
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Does this make sense?
So next time you hear someone say, “Deal A is better than Deal B because of the cap rate,” don’t just automatically agree. Ask more questions. Get under the hood.
And don’t forget to pick up Brian’s BP book, The Hands-Off Investor. While you’re waiting for it to arrive, here is another brilliant post on cap rate myths from Brian.
Do you agree with Brian and Paul? How have you seen cap rate misunderstood or misapplied as you analyze and invest in commercial real estate property?