There was a pause on the other end of the line, and then he said… “You literally just blew my mind.”

This was the response I received after sharing with a new friend a powerful example of how using cap rates – when properly understood – to your advantage, can dramatically increase the bottom line of a value-add investor in the multifamily space. This simple insight dramatically changed the mindset of an experienced single-family investor getting his start in multifamily.

It was such a fun conversation I just had to share it.

He had recently bought a couple multifamily properties (11 units & 16 units) in a high cap rate market. He wanted to invest in that type of market because with a higher projected yield, he’d have greater cash flow. That logic is both sound and correct, but once we went through some numbers comparing cap rates in different markets, he had a whole new mindset…

It’s a bit trendy these days to “chase yield”. As investors, most of us know the market we live in the best. We are familiar with what values have been over a long period of time, and we have strong opinions of what those values “should” be.

It is somewhat ironic, that even though real estate is largely a local business, many investors look to markets outside their own, because the cap rates, yields, or returns appear to be higher in other markets.

I’ll be the first to admit it is much harder to generate a robust cash on cash return in low cap rate markets when you’re fully levered. It is the nature of the beast. But there is more to this multifamily investing game than just cash flow.

What determines the best strategy for you really comes back to your goals and what you are trying to accomplish. If cash flow is the only thing that matters, it might make a lot of sense to invest in high cap rate, higher yield markets.
But what about appreciation? Especially forcing appreciation, or building your net worth?

Most investors I visit with as a capital advisor are looking for value-add deals. They want that “pop” in value. Sure, the cash flow is part of the consideration, but a couple percentage points of higher cash on cash return isn’t going to change your life. But hundreds of thousands of dollars in equity creation is significant enough to be felt.

Back to the example that “blew” this investor’s mind.
The example is simple – assume you can increase the NOI by $3,000 per month through better management, property improvements, and additional other income. Let’s say you buy a 30-unit property and you’re able to realize a net NOI gain of $100 per unit per month.

$100 multiplied by 30 units equals a $3,000 monthly increase in NOI; which multiplied by 12 months produces an additional $36,000 annually.

Apply a 4% cap rate to that and you have created $900,000 of value ($36,000/.04 = $900,000)

Apply an 8% cap rate to that same work and you’ve created $450,000 of value ($36,000/.08 = $450,000)

Makes a ton of sense.

But let’s take it a step further.

Let’s assume the property is worth $4,000,000 and you had to put $1,000,000 down to get the loan. After debt service you get a 5% cash on cash return so $50,000 per year. It would take you 9 years to make up that difference in value creation and that is assuming zero cash flow from the property in the low cap rate market.

In terms of an equity multiple, doing the exact same work in a low cap market gives you an equity multiple of 1.9x as opposed to a 1.45x multiple in a high cap market.

What if that takes you 2 years to get in and out? And then you do it 5 times in 10 years? If you only use that initial $1 million, you will have turned it into $5.5 million. If you compound those returns could grow to around $30 million!

I’m certainly not lobbying for everyone to go out and invest in a low cap rate market, what I am suggesting is there may be incredible opportunities in your own back yard if you look at things from a different perspective.

If we look at some of the biggest players like REITs and institutional investors, they put their money in very established strong markets where the cap rates are low. We’re talking about the top 25-50 markets in the US. They realize that appreciation in a 3 or 4 cap rate market is much greater than appreciation in a 7% or 8% cap market. And there are a lot of very smart and experienced individuals making these decisions.

As with just about everything in life, there isn’t a blanket statement or universal strategy that applies to everyone. Without question, at least 80% of the investors I speak with are looking for value add deals. They are in the mode of building a portfolio that will eventually become large enough to be completely passive.

A fantastic way to build that portfolio is to force appreciation through value-add opportunities. It is essentially the same amount of work to add value to a property in Seattle as it is in Elko, Nevada. And even with the same level of income increase through your hard work and intelligence, different markets will yield far different results to your bottom line.

Try it on and see if it fits. Does it make sense to open your search to markets that may have seemed “too expensive” previously?

If so, a great financing tool that I’m seeing more investors use is a bridge loan. More on that next week…