August 2019 Anthony Walker, Buckingham Investments
For those of us living in Southern California, it’s hard to read or listen to anything in the multi-family investing community these days without some discussion of less expensive out-of-state opportunities. Seeing as $1 million dollars barely buys a starter property in many local areas, this comes as no surprise. Other markets can offer a lower cost of entry, greater scale, and higher cash flow.
So, why then is our local market still experiencing so much demand? Inventory remains low, sales volume is strong, and a huge amount of demand is clearly present. Is all of this money missing the boat, or do these investors know something many haven’t considered? Perhaps the market is smarter than we realize and there are alternative strategies at play.
Let’s analyze a commonly used metric for evaluating multi-family investments: The Capitalization (cap) Rate. Mathematically, a cap rate for a property is calculated by dividing the Net Operating Income (NOI) by the building’s price or value: Cap% = NOI/Price. It’s often said that the cap rate is the all cash return you’d receive on your investment from operations if you purchased with no debt. It’s a useful metric for comparing different properties or different areas to each other. Generally, higher is seen as better since that means more cash flow. Cap rates are a great market comparison metric as they allow us to compare properties of different sizes to each other and decide which offers us a better return.
Although a higher cap rate can indicate an investment likely to produce higher cash flow, is it really the best strategy to just go online and buy the property and area with the highest cap rate you can possibly find? Let’s dig a little deeper into the metric and think about this. When a cap rate is used as a market descriptor, it’s actually an indication of what yield investors are willing to accept on their money in that market. Think about the implications of that statement. If investors are willing to accept a 3-5% yield on their invested capital in SoCal, but require an 8-10% yield in another area, the market is telling us the same dollar of income is worth twice as much or more here in our expensive local market. This is an illustration that more fundamentally, cap rates are an expression of risk. Investors require that higher yield in areas that the market sees as more risky.
Understanding this risk trade-off should be key to any investor’s strategy. Think about the implications of this concept across a variety of topics when comparing deals:
- Supply and demand characteristics – availability of land to build and demand for units
- Trade-off between cash flow and appreciation
- Performance during market downturns
- Local economy
- Value-add mechanics – what is each dollar of increased income worth?
- Rent growth implications and vacancy rates
Let’s discuss all of these interrelated considerations and what they might mean for our investment strategy. There’s not one right answer to this question, each of us is on our own investment journey according to our own goals.