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What advantages of Buying in an Expensive, Low Cap Rate Market?

Those who know me well, know three things are true about me. One, I am not bashful. Two, I am good at what I do. Three, I like to teach—when I have the time.

This said, the equity stack for our latest purchase is oversubscribed and I am able to relax for a couple of days. And, thus, while in transit to my niece’s wedding, I wonder if I could offer you a few thoughts.

This will be short and to the point, but hopefully, you’ll get value!

The Advantages of Low Cap Rate Markets

The cap rates are compressed all across the country, as you know, which they have been. The unemployment is at historic low levels. The homeownership rate is basically back to historical norms. The millennials want to rent and so do the baby-boomers. The demand for a mid-range quality apartment product is profound.

When the interest rates increased about a year ago, the cap rates did not inflate. Now that the interest rates are coming down, the cap rates are not compressing meaningfully. It seems we’ve found a baseline where, relative to the fundamentals, the cap rates are “happy.”

The cap rates have been low, are low, and my guess is that they will continue to stay here for a while.

There are those who complain about the low cap rates. Personally, I love it, and here’s why.

1. Low Cap Rates Are Hard to Underwrite

Most investors don’t know how to underwrite low cap rates. Most are scared of low cap rates. This, as far as I can tell, creates an opportunity for me.

2. Cap Rate Is Low for a Reason

The cap rate is a measure of market sentiment. The more people pay for the net operating income (NOI), the lower the resulting cap rate. By definition, a low cap rate is indicative of bullish sentiment.

3. Equity (and Cash Flow)

You are probably saying to yourself right now, “What returns?! There is no cash flow in a 5 percent cap market.”

My response to that is twofold. First, people going to such a market don’t need cash flow. These folks already have more money than they know what to do with, and they are primarily looking for safety. They are the folks looking to pass their wealth onto the next generation.

Secondly, you are not one of them. So, you need to buy assets at 5 percent cap, which you can improve to a 7.5 percent cap, at which point two things happen. One is you can cash flow 7.5 percent cap just fine if you’d like. Or two, you can sell to one of the folks in the first category at a 5 percent cap, and make a rather impressive Delta, which brings me to my next point.

4. Value-Add Is Easier in a Growth Market

Question: Is it easier to bump rents in a growing market, where the population and incomes are on the rise, or in a market where nothing is happening?

5. CapEx Leverage

Improving the NOI by $100,000 in a 5 percent cap market capitalizes to a value of $2 million. Improving the NOI by the same $100,000 in a 10 percent cap market capitalizes to $1 million of value.

Now, I know I am old and my math ain’t 20/20 no more, but I think $2 million is better than $1 million—for the same effort.

6. More Buyers at the Exit

Buyers like safety and stable returns. I want buyers when I am ready to sell. The more the better.

7. Why Bigger Is Better When It Comes to Commercial Real Estate Deals

Many real estate investors start out like I did with that first duplex before investing in single-family residences (SFRs) and then later trying to move into commercial deals.

At one point, I was well on my way to owning 100 houses, but that was before I changed my strategy.

What caused the shift was gaining experience working as a property manager while selling rentals almost exclusively to real estate investors in my network. Between eviction court, inspections, turnovers, and routine maintenance, I quickly realized how much time and how many headaches were involved, and I started to question my strategy.

Commercial Real Estate & Financing

It wasn’t long after I purchased a 6-unit building with commercial financing that I realized some of the risks that I was taking on. I thought it would just be a normal transition into small apartment buildings. I figured, like many of my friends, that I could own more units, just under one roof and in one location.

What could possibly go wrong? If one unit was empty, I had all the other units to help pay the mortgage, right?

Little did I know the impact of commercial financing and the fact that I didn’t have enough scale (or number of units) to justify on-site management and maintenance.


Recasting basically means the bank can adjust the loan at a later point in time, usually after five or seven years (sometimes even 10 years), usually to lower their exposure to interest rate risk.

The bank may take a look at the borrower and the property again to see if they still qualify for the existing loan to be extended. If they do qualify, this typically means the property hasn’t dropped in value (potentially jeopardizing the bank’s equity position) and nothing has materially changed in a negative way to impact the borrower’s financial picture.

Once you exceed 70-100 units, banks usually won’t be sticklers about getting you to personally sign on the loan. These situations are much safer for the real estate investor in many ways. By not having to sign, there’s much less personal risk, especially with exposing any of your other assets.

On-Site vs. Third-Party Maintenance

Also, there’s enough scale with the number of units that you can start to justify on-site management and maintenance. You know how I know? I was a painting contractor who did multiple apartment complexes from 2 units to 600 units and everything in between. If you only had between 4 and 70 units, you pretty much had to bring in your entire maintenance team from outside. This can dramatically impact the bottom line, especially since apartments have much more common area maintenance and a higher turnover rate than SFRs.

The other advantage of these larger apartment complexes is that they’re often purchased with private equity or capital that’s raised through the use of a private placement memorandum (PPM). The PPM not only protects the investors in the deal, but it also protects the fundraiser in the event that things don’t work out. It’s almost like an insurance policy on the deal.

Personally, if I’m going into commercial investing such as apartments, I definitely want deals in excess of 100 units. Otherwise, I’ll just stick to my SFRs.

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