I just saw someone touting the “Top Markets” for real estate investors, based on their apparently high “cap rates.”
Investors following advice to invest in these markets are probably taking on way more risk than they think. But why is that?
Multifamily real estate investors use cap rates to determine the unleveraged return on an asset. In other words, if the property was not mortgaged and you used 100% cash to purchase it, the cap rate would represent the return the property would pay, before capital expenses. It’s calculated by dividing the property’s net operating income (i.e., operating income minus operating expenses) by the purchase price. The cap rate bears an inverse relationship to the value of the asset – the lower the cap rate, the more expensive the asset is relative to net operating income.
But it’s important for new multifamily real estate investors to understand that cap rates aren’t just a number indicating the return on an investment.
That’s because cap rates also reflect the market’s assessment of an investment’s risk. The higher the perceived risk, the higher the cap rate must be. This is known as a “risk premium” – the market demands more return to take on more risk.
The fact, in a time of historically low cap rates, that cap rates remain high in these areas relative to other areas tells the sophisticated multifamily real estate investor something about the market’s view of these areas.
In fact, practically every one of the “top markets” on this list would also be found on a list of “most distressed rust belt cities,” markets where jobs and people have been leaving for decades.
Just because assets in these markets look cheap doesn’t mean they actually are cheap. They’re only cheap compared to assets in markets that investors feel have better fundamentals, including strong population growth and healthy economic outlooks.
Moreover, sophisticated multifamily real estate investors know to look at cap rates in their historical context. Markets with apparently attractive cap rates of 10% or higher right now may usually trade at cap rates of 15% or higher. So, these markets may look cheap compared to OTHER markets, but they are expensive relative to their own historical performance.
If you find a market with strong fundamentals AND high cap rates, you have a buying opportunity. But that’s not what’s going on here. Here, you have investors desperate to generate returns, venturing into markets they wouldn’t have touched with a barge pole just a couple of years ago. And they’re declaring themselves geniuses for finding “hidden” opportunities!
If a market has assets trading at a 10-cap right now, in this time of historically low cap rates, what do you think happens to cap rates there when the market returns to normal, as it always does?
And what happens to the value of assets there when that happens?
Do you really want to invest there now?