What’s the more profitable apartment deal – a 2% cap rate in Manhattan or a 10% cap rate in Stillwater, Oklahoma?
If you’re answer was the 2% cap rate deal in Manhattan, you’re wrong.
If you’re answer was the 10% cap rate deal in Stillwater, don’t get too excited, because you are also wrong.
The correct answer is that it depends.
Capitalization rates are relevant when analyzing multifamily deals, but it is nowhere near the top of the list of the most important factors.
Let me elaborate with an example.
A passive investor who invests with my company also invests with a value-add syndication group in Manhattan that purchases rent stabilized, 2% cap rate apartments. They purchase these assets because they were able to identify a unique way to add value. On rent stabilized properties in New York City, it is common for residents to pass their rent stabilized lease to someone else who does not qualify for the lower rental rate while claiming to still live there. This group implements a system that minimizes the occurrence of this sort of lease transfer, which allows them to increase the net operating income after purchase, resulting in a cash flow that is greater than the cash flow from a 10% cap rate property in a rural market.
Since it is a 2% cap rate property, even a minor increase to the net operating income has a massive effect on the value. In addition to the benefits from the increase in cash flow, the group can also sell the property to someone who is looking to purchase a 2% cap rate property in Manhattan with the hopes of gaining from natural appreciation at a price based on the new, increased NOI. We personally do not buy for appreciation, only cash flow, but there are investors who do, especially in markets like New York City.
The moral of the story? The business plan is more important that the capitalization rate for every apartment deal.
The cap rate can indicate the current, in-place cap rate, but it cannot tell you by how much you can increase the net operating income, which is vastly more important. The business plan can.
Rather than asking yourself or a syndicator “what is the cap rate you/I are/am buying this deal at?”, a better question is “what is the business plan you/I will implement after purchasing the deal?”
Of course, not all business plans are equal. The best business plans have been (1) implemented by the syndicator in the past and (2) implemented by the syndicator’s team in the past.
For example, let’s say the business plan is to spend $5,000 per unit in interior renovations to increase the rents by $100. Sounds like a good plan, right? Well, only if the syndicator and their team has successfully implemented a similar business plan in the past. Additionally, the business plan goes from “good” to “great” if the seller has already proven the business plan (i.e., they’ve renovated a portion of the units for $5,000 and are already demanding the $100 rental premium).
If the seller hasn’t proven the business plan, then the proof is in the competition. To strengthen the business plan, the syndicator should look at the direct competitors (i.e., the rental comps) in the market to determine the rents they are demanding. Then, they identify how much it would cost in renovations to achieve the same rents as the competition at the subject property.
Related: What is Apartment Syndication?
Now, the cap rate is still a relevant factor and you want to make sure you are buying competitively (or ideally, favorably), but a proven business plan implemented by a proven team is where the real money is made.
Want to learn how to build an apartment syndication empire? Purchase the world’s first and only comprehensive book on the exact step-by-step process for completing your first apartment syndication: Best Ever Apartment Syndication Book.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.