Why you should consider more than just the cap rate
Ok, Cap rates are important. However, they are such a small part of your decision-making process. The amount of times I hear “I only buy seven cap deals” is disturbing. If you think evaluating commercial multifamily apartments is as easy as looking at a cap rate and then saying yes or no, you’re delusional. That would be like Warren buffet saying, “oh yeah, I just stare at the Earnings per share on a stock, and if it’s not x, then I don’t buy.”
Cap rates are one part of a large equation. You have to consider the potential upside, such as rental increases, RUBS additions, or other forms of supplemental income (make sure the local sub-market will support these additions) that the complex in question is currently not taking advantage of. You have to look at the expenses and decide why are they are either too high or too low and how can you change them with an effective business plan. ALSO, running the business plan by your property manager or potential property management partner, prior to you even submitting an offer. You have to see if the business plan is going to actually be possible to carry out. All of your projections mean nothing if the back-end partner can’t actually make them a reality.
Cap rate formula for valuing real estate
A cap rate is merely one lever in the value formula of NOI/Cap rate = purchase price. When you consider the exit sale, you’ll see that if you increase your NOI during the hold period, the low cap rate benefits you and has the effect of making your sale price even higher. Low cap now becomes a pro, not a con.
Cap rate as an assessment of risk
A cap rate is a metric of price, but it’s also an indirect assessment of risk. The lower the cap rate, the more demand and the more potential exit buyers you have available to you. If you buy a 10-cap deal in the middle of Idaho, it may be a good upfront at the buy, but if anything happens to the industry in the town, your vacancy will skyrocket and then you’re left with an apartment that no one in the world will buy from you. Bottom line: you get what you pay for.
In conclusion, cap rates are an essential thing to take note of, but please do not stop your analysis at the cap rate. Please consider the whole picture, and please do not say that you “only buy seven caps hands down nothing else.” Open your mind and be flexible with new information on a case-by-case basis.